This assignment does not use real world data; it involves solving a model similar to that in lectures. We use the following terminology in this part: aggregate income Y and disposable income Yd (= Y − T), consumption function C(Yd), planned investment function I(r), government spending G, and taxation T = tY where t is the marginal tax rate; r% denotes the real interest rate in the economy.
(Note, r is in percentage points, e.g. r = 2 means the interest rate is 2%. When doing calculations, the interest rate should not simply be inserted in decimal form. For example, if r = 5 then I(5) = 52 − 0.2 × 5 = 51.) Consider a hypothetical economy where: C(Yd) = 30 + 2/3 × (Y − T) I(r) = 52 − 0.2 × r G = 160 t = 0.4 (represents 40%)
FOR ALL ANSWERS SHOW WORKING AND ADD DIAGRAMS
1. What are the equilibrium values of the interest rate, r, and investment, I? (Hint: use the MP R or IS, and I(r) equations.)
2. Suppose that the level of Government expenditure increases to G = 180. What is the equilibrium value of aggregate income, Y ? (Note: you will no longer get a round number for Y .)
3. What are the new equilibrium values of the interest rate, r, and investment, I?
4. Discuss why how the increase in G impacts Y , r and I in the context of the ideas of fiscal stimulus, spending multipliers, and crowding-out.