Suppose that the consumption function is C = 100 + 0.8(Y-T), that investments are 60, that government spending is 200 and taxes are flat rate at income T = 225

a) What is the equilibrium GDP?

Suppose the government decides to increase its spending by 50 and finance this increase by simultaneously increasing taxes by 50 (which therefore increase to 275).

b) What is the effect of this change on the government's budget balance?

c) What is the effect on equilibrium GDP? Explain why the effect is not zero.

d) In practice, are there limits to governments using this approach to boost GDP?

Consider the One-Period Model.

Suppose that the production function that the rm operates is now given by
Y = z(G)F(K;N^d); with z(G) = (z + aG);
where z > 0, a > 0, and G > 0 is government spending.

Notice that in this framework government spending makes firms more productive (for
For example, government expenditures on roads and bridges lower the cost of transportation).
The budget constraint for the government is G = T, where T is lump-sum taxes.

1. Suppose that the government decides to increase G. Using a diagram, determine the
equilibrium effects of this shock on aggregate output, consumption, employment, and
the real wage. Show that increasing G can potentially increase welfare.

2. Compare your results with the case of unproductive government spending studied in
class (i.e., when a = 0).

Consider an economy in which autonomous consumption is 800, the marginal propensity to consume is 0.8, investment is 400, government spending is 500, taxation is 400, and net exports are 100.

A. What is the equilibrium GDP in this economy? Show your work. (3 points)

B. What is the savings at this level of GDP? Show your work. (3 points)

C. What are the spending and tax multipliers? Show your work. (4 points)

D. If government spending increases by 200, what is the new equilibrium GDP and what is the increase over the original equilibrium GDP? Show your work. (4 points)

E. If the government increases both spending and taxation by 200, what is the new equilibrium GDP, and what is the increase over the original equilibrium GDP? Show your work. (4 points)

Suppose that government spending makes private firms more productive; for example, government spending on roads and bridges lowers the cost of transportation. This means that there are now two effects of government spending, the first being the effects discussed in this chapter of an increase in G and the second being similar to the effects of an increase in the nation’s capital stock K.

a. Show that an increase in government spending that is productive in this fashion could increase welfare for the representative consumer.

b. Show that the equilibrium effects on consumption and hours worked for an increase in government spending of this type are ambiguous but that output increases. You must consider income and substitution effects to show this.