ECON1002 Introductory Macroeconomics, Semester 2, 2024 1
TUTORIAL 6
(Week beginning Sept. 2)
READING GUIDE: REVIEW WEEK 4&5 LECTURE AND TEXTBOOK CHS 7 AND 8.
Key Concepts: Balanced budget multiplier, Automatic stabilisers, Government budget
constraint, Stance of fiscal policy, Deficits and Public debt.
REVIEW OF CONCEPTUAL UNDERSTANDING
These are to be attempted before the tutorial. They will not normally be covered in
the tutorial, maybe, except for a quick review, time permitting. The answers are
typically found in the textbook and lecture notes.
1. What do you understand by the balanced budget multiplier? Why do taxes and
government purchases have different impacts on the economy? Explain.
2. What are the limitations of fiscal policy as a stabilisation tool? Discuss why using
fiscal policy to stabilize the economy is more complicated than suggested by the basic
Keynesian model.
3. Why is the intergenerational consideration important for fiscal policy? What is the
economic rationale for the ‘Future Fund’?
4. What adjustments would have to be made to correctly assess the stance of fiscal policy
and why?
5. What is the relation between fiscal policy and the public debt?
PRACTICE PROBLEMS (FOR IN-CLASS DISCUSSION)
STUDENTS SHOULD BE PREPARED TO PRESENT ANSWERS TO THE PROBLEMS WITH AN ASTERISK (*).
N.B. THERE ARE 3 PROBLEMS WITH * THIS WEEK. ANY TWO PROBLEMS WITH * CAN BE CHOSEN FOR
STUDENTS TEAM BASED PRESENTATION.
*1. Consider a 3-setor economy and its PAE = 50 + 0.7Y, which sets the equilibrium output to
potential output.
a. Determine the equilibrium income and the size of multiplier.
b. If the tax rate (t) is 0.1, what is the marginal propensity to consumer?
c. Assume there is an exogenous decrease in investment spending by 10 units due to a
pessimistic expectations about the economy (business’ expectations were called
‘animal spirits’ by Keynes). Determine the new equilibrium output and output gap.
d. Suppose that government wants to use a tax cut (i.e., a lower t) to eliminate the output
gap in (c). Determine the new tax rate to achieve this goal.
2. An economy is initially at full employment, but a decrease in planned investment
spending (a component of exogenous expenditure) pushes the economy into recession.
Assume that the marginal propensity to consume (MPC) of this economy is 0.75 and that
the multiplier is 4.
a. How large is the contractionary gap after the fall in planned investment?
b. By how much would the government have to change its purchases to restore the
economy to full employment?
Tutorial Tasks
ECON1002 Introductory Macroeconomics, Semester 2, 2024 2
c. Referring to your answer for part (b), would an equivalent change in taxes produce the
same result? Explain.
d. Suppose that the government’s budget is initially in balance, with government spending
equal to taxes collected. A balanced-budget law forbids the government from running a
deficit. Is there anything that fiscal policy makers could do to restore full employment in
this economy, assuming they do not want to violate the balanced-budget law?
*3. An economy is described by the following equations:
C = 40 + 0.8(Y – T)
IP = 70
G = 120
NX = 10
T = 150
Y* = 580
a. What is the size of the multiplier in this economy?
b. Find the numerical equation relating planned aggregate expenditure to output.
c. By how much would government purchases have to change in order to eliminate any
output gap?
d. Suppose that government is considering a tax cut (or increase), rather than changing
purchases, to eliminate the output gap in the above economy. By how much would
taxes have to change?
*4. This problem illustrates the workings of automatic stabilizers. Suppose that the
components of planned aggregate expenditure in a 4-sector economy are:
C = 400 + 0.8(Y – T), T = tY, with exogenous components IP, G and NX.
Note that t is the fraction of income paid in taxes (the tax rate). As we will see in this
problem, a tax system of this sort serves as an automatic stabiliser, because taxes collected
automatically fall when incomes fall.
a. Find an algebraic expression for short-run equilibrium output in this economy.
b. Find an algebraic expression for the multiplier. Compare the expression you found to
the formula for the multiplier when taxes are fully exogenous as in Problem 1 above.
c. Show that making taxes proportional to income reduces the multiplier. Explain how
reducing the size of the multiplier helps to stabilize the economy, other things constant.
d. Assume the following values:
X = 0, M = 0, MPC = 0.8, and t = 0.25.
Calculate numerical values for short-run equilibrium output and the multiplier.
5. Refer to lecture slides (Week 5) and the following equation showing the dynamics of
debt and deficits.
= +
Explain what you understand by the equation. From the equation, what determines a
country’s level of public debt?
Tutorial Tasks
