7. Suppose economists observe that an increase ingovernment spending of $10 billion raises the totaldemand for goods and services by $30 billion.
a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?
b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?
8. An economy is operating with output that is $400 billion below its natural level, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run. In what direction and by how much would government spending need to change to close the recessionary gap? Explain your thinking.
9. Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve held the money supply constant in response or if the Fed were committed to maintaining a fixed interest rate? Explain.
10. In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain.
a. When the investment accelerator is large or when it is small?
b. When the interest sensitivity of investment is large or when it is small?
11. Consider an economy described by the following equations:
𝑌=𝐶+𝐼+𝐺
𝐶=100+0.75(𝑌−𝑇)
𝐼=500−50𝑟
𝐺=125
𝑇=100
where Y is GDP, C is consumption, I is investment, G is government purchases, T is taxes, and r is the interest rate. If the economy were at full employment (that is, at its natural rate), GDP would be 2,000.
a. Explain the meaning of each of these equations.
b. What is the marginal propensity to consume in this economy?
c. Suppose the central bank’s policy is to adjust the money supply to maintain the interest rate at 4 percent, so r = 4. Solve for GDP. How does it compare to the full-employment level?
d. Assuming no change in monetary policy, what change in government purchases would restore full employment?
e. Assuming no change in fiscal policy, what change in the interest rate would restore full employment?