ECS2602 Assignment 2 Semester 1 & 2 2021

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The government increases government purchases/spending. (illustration 1) If government purchases increase, then the government-purchases multiplier tells us that the IS curve shifts to the right by ... an amount equal to [1/(1 – MPC)]ΔG. Income and the interest rate both increase. The increase in disposable income causes consumption to rise, while the increase in the interest rate causes investment to fall. (illustration 1)The government increasestaxes. (illustration 2) If the government increases taxes, then the tax multiplier tells us that the IS curve shifts to the left by an amount equal to [–MPC/(1 – MPC)]ΔT. This is shown in (illustration 2). Income and the interest rate both fall. Disposable income falls because income is lower and taxes are higher; this causes consumption to fall. The fall in the interest rate causes investment to rise. (illustration 2) The government increases government purchases/spending and taxes by equal amounts. (illustration 3)We can figure out how much the IS curve shifts in response to an equal increase in government purchases/spending and taxes by adding together the two multiplier effects that we used in parts (b) and (c): ΔY = [(1/(1 – MPC))] ΔG] – [(MPC/(1 – MPC)) ΔT] Because government purchases/spending and taxesincrease by the same amount, we know that ΔG = ΔT. Therefore, we can rewrite the above equation as: ΔY = [(1/(1 – MPC)) – (MPC/(1 – MPC))] ΔG * ΔY = [(1–MPC)/(1 – MPC)] ΔG * ΔY = ΔG. This expression tells us how output changes, holding the interest rate constant. It says that an equal increase in government purchases and taxes shifts the IS curve to the right by the amount that G increases. This shift is shown in <Figure 4>. In the figure, we can see that the amount that IS curve shifts horizontally is ΔG. This is the amount by how much the Planned Expenditure changes. However, this is different from how much equilibrium Y changes. In equilibrium, we need to look at the points where the IS and LM curves intersect. Therefore, the actual change in equilibrium income ΔY = Y2-Y1 <ΔG. To see what happens to consumption, let’s examine the disposable income Y – T. We can express this as: Change in disposable income = ΔY – ΔT (Don’t confuse this with %Change, or %Δ. This is simply a change in the value itself). From above, output increases by less than ΔG, but we also know, from what is given in the problem, that ΔT = ΔG. As a result, Change in disposable income = ΔY – ΔT < 0. Since there is a decrease in disposable income, consumption also decreases. The interest rate rises, causing investment to fall. [Show More]

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