ECON 202 – Economics II
Fall 2005 – Homework Assignment 5
Professor: Maria Pia Olivero
NAME: _______________________________________________
MULTIPLE CHOICE SECTION
(20 points, 2 points each)
1) If (MPC+MPS)=1 where MPS is the marginal propensity to save, then the formula for the expenditure multiplier is:
a. 1/MPC
b. 1/MPS
c. 1/(1-MPS)
d. 1/(1+MPS)
2) The economy is in equilibrium at an output level of 2,000. Now planned investment increases. At the initial output level, all of the following are true except:
a. Aggregate expenditure is greater than aggregate output
b. Savings is less than planned investment
c. Inventory levels are rising unexpectedly
d. Consumption level has remained unchanged
3) MPC equals 0.9. Consumers receive an extra $100 dollars of income. We can say that:
a. The consumption function has moved upwards
b. The consumption function has moved downwards
c. Consumption spending increases by $100
d. Savings increase by $10
4) Until recently the mountainous nation of Tebit has been cut off from the rest of the world. An active international sector has now been created. Despite this, the country has pursued a policy of ensuring that the trade balance is always zero. As a result of its new openness the AE function will:
a. not shift
b. become flatter
c. become steeper
d. shift upwards
5) In Arboc, the income tax is 20% and the MPC = 0.75. The government spending multiplier is:
a. 2.5
b. 3
c. 3.75
d. 4.0
6) In Macronesia, the MPC is approximately .80. If disposable income changes from 1,000 billion pukas to 1,500 billion pukas, then consumption will change by a(n)
a. decrease of 500 billion pukas.
b. increase of 500 billion pukas.
c. increase of 400 billion pukas.
d. increase of 800 billion pukas.
7) The reason why inflation reduces the value of the multiplier is that part of the change in demand is
a. absorbed by price changes.
b. saved rather than spent.
c. matched by changes in supply.
d. matched by changes in income.
8) If Japanese consumers save most of their tax cut, this means that, compared to government spending changes,
a. tax changes would have a higher multiplier effect.
b. tax changes would have a weaker multiplier effect.
c. government spending would have a weaker multiplier effect.
d. Japanese consumers would spend all of their tax cut.
9) Assume that taxes depend on income. The MPC is 0.8 and t=0.25. The tax multiplier is:
a. -1.67
b. -2
c. –2.5
d. 10
10) Assume that taxes depend on income. The MPC is 0.5 and t=0.2. If government spending increases by $10 billion, the equilibrium level of output increases by:
a. $16.7 billion
b. $25 billion
c. $50 billion
d. $100 billion
SHORT ANSWER SECTION
Question 1: (25 points)
The Arbezani Minister of Economy gives you the following data about his country:
C = 300 + 0.75 Y
I = 200
AE = C + I
AE = Y
a. Calculate the marginal propensity to consume and the marginal propensity to save (5 points)
b. Derive the algebraic formula for the savings function knowing that C+S=Y (10 points)
c. Calculate the equilibrium income (10 points)
Question 2: (15 points, 5 points each)
Suppose the government reduces taxes by $20 billion and that the MPC is ¾.
a) What is the initial (1st round impact) effect of the tax reduction on aggregate demand?
b) What additional effects follow this initial effect (i.e., what is the total effect of the tax cut on AD)?
c) How does the total effect of this $20 billion tax cut compare to the effect of an $20 billion increase in government spending? Why? Quantify the effect of an increase in G for full credit.
Question 3: (15 points)
Suppose private investment increases by $10 billion and that the MPC is 0.75.
a) What is the initial (1st round) effect on aggregate expenditure? (5 points)
b) What additional effects follow this initial effect, ie what is the total effect? (5 points)
c) Which is the total effect on output of an increase in government expenditure of $10 billion together with a tax increase of $10 bn (flat or lump sum taxes) so that the budget keeps balanced? (5 points)
Question 4 (15 points)
What are the three main reasons why the expenditure multiplier (1/(1-MPC)) is an oversimplified one? (5 pts. each)
Question 5 (10 points)
If the main assumption of Keynesian theory is that prices are fixed / constant (i.e. that they do not react to changes in demand), what does this theory imply regarding the shape of the aggregate supply curve in the economy?