Macroeconomics principles v1 0

Macroeconomics Principles v 1.0 This is the book Macroeconomics Principles (v 1.0) This book is licensed under a Creative Commons by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/) license See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and make it available to everyone else under the same terms This book was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz (http://lardbucket.org) in an effort to preserve the availability of this book Normally, the author and publisher would be credited here However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed Additionally, per the publisher's request, their name has been removed in some passages More information is available on this project's attribution page (http://2012books.lardbucket.org/attribution.html?utm_source=header) For more information on the source of this book, or why it is available for free, please see the project's home page (http://2012books.lardbucket.org/) You can browse or download additional books there ii Table of Contents About the Authors Acknowledgments Preface Chapter 1: Economics: The Study of Choice Defining Economics 10 The Field of Economics 18 The Economists’ Tool Kit 30 Review and Practice 38 Chapter 2: Confronting Scarcity: Choices in Production 42 Factors of Production 44 The Production Possibilities Curve 52 Applications of the Production Possibilities Model 71 Review and Practice 86 Chapter 3: Demand and Supply 95 Demand 97 Supply 111 Demand, Supply, and Equilibrium 123 Review and Practice 141 Chapter 4: Applications of Demand and Supply 149 Putting Demand and Supply to Work 151 Government Intervention in Market Prices: Price Floors and Price Ceilings 163 The Market for Health-Care Services 173 Review and Practice 182 Chapter 5: Macroeconomics: The Big Picture 187 Growth of Real GDP and Business Cycles 190 Price-Level Changes 200 Unemployment 216 Review and Practice 227 Chapter 6: Measuring Total Output and Income 232 Measuring Total Output 234 Measuring Total Income 251 GDP and Economic Well-Being 260 Review and Practice 270 iii Chapter 7: Aggregate Demand and Aggregate Supply 276 Aggregate Demand 278 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 290 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 304 Review and Practice 317 Chapter 8: Economic Growth 324 The Significance of Economic Growth 326 Growth and the Long-Run Aggregate Supply Curve 336 Determinants of Economic Growth 346 Review and Practice 353 Chapter 9: The Nature and Creation of Money 359 What Is Money? 361 The Banking System and Money Creation 371 The Federal Reserve System 386 Review and Practice 395 Chapter 10: Financial Markets and the Economy 401 The Bond and Foreign Exchange Markets 403 Demand, Supply, and Equilibrium in the Money Market 414 Review and Practice 431 Chapter 11: Monetary Policy and the Fed 437 Monetary Policy in the United States 439 Problems and Controversies of Monetary Policy 451 Monetary Policy and the Equation of Exchange 464 Review and Practice 475 Chapter 12: Government and Fiscal Policy 482 Government and the Economy 484 The Use of Fiscal Policy to Stabilize the Economy 496 Issues in Fiscal Policy 507 Review and Practice 515 Chapter 13: Consumption and the Aggregate Expenditures Model 521 Determining the Level of Consumption 522 The Aggregate Expenditures Model 535 Aggregate Expenditures and Aggregate Demand 558 Review and Practice 566 iv Chapter 14: Investment and Economic Activity 573 The Role and Nature of Investment 575 Determinants of Investment 584 Investment and the Economy 595 Review and Practice 600 Chapter 15: Net Exports and International Finance 606 The International Sector: An Introduction 608 International Finance 620 Exchange Rate Systems 632 Review and Practice 643 Chapter 16: Inflation and Unemployment 649 Relating Inflation and Unemployment 651 Explaining Inflation–Unemployment Relationships 660 Inflation and Unemployment in the Long Run 669 Review and Practice 682 Chapter 17: A Brief History of Macroeconomic Thought and Policy 689 The Great Depression and Keynesian Economics 691 Keynesian Economics in the 1960s and 1970s 701 An Emerging Consensus: Macroeconomics for the Twenty-First Century 715 Review and Practice 728 Chapter 18: Inequality, Poverty, and Discrimination 732 Income Inequality 735 The Economics of Poverty 746 The Economics of Discrimination 762 Review and Practice 771 Chapter 19: Economic Development 777 The Nature and Challenge of Economic Development 780 Population Growth and Economic Development 795 Keys to Economic Development 805 Review and Practice 815 Chapter 20: Socialist Economies in Transition 818 The Theory and Practice of Socialism 820 Socialist Systems in Action 828 Economies in Transition: China and Russia 837 Review and Practice 851 v Appendix A: Graphs in Economics 853 How to Construct and Interpret Graphs 854 Nonlinear Relationships and Graphs without Numbers 870 Using Graphs and Charts to Show Values of Variables 878 Appendix B: Extensions of the Aggregate Expenditures Model 890 The Algebra of Equilibrium 891 The Aggregate Expenditures Model and Fiscal Policy 895 Review and Practice 901 vi About the Authors Libby Rittenberg Libby Rittenberg has been a Professor of Economics at Colorado College in Colorado Springs since 1989 She teaches principles of economics, intermediate macroeconomic theory, comparative economic systems, and international political economy She received her B A in economics-mathematics and Spanish from Simmons College and her Ph.D in economics from Rutgers University Prior to joining the faculty at Colorado College, she taught at Lafayette College and at the Rutgers University Graduate School of Management She served as a Fulbright Scholar in Istanbul, Turkey, and as a research economist at Mathematica, Inc in Princeton, New Jersey Dr Rittenberg specializes in the internationally oriented areas of economics, with numerous articles in journals and books on comparative and development economics Much of her work focuses on transition issues and on the Turkish economy She has been very involved in study abroad education and has directed programs in central Europe and Turkey Tim Tregarthen There is one word that captures the essence of Dr Timothy Tregarthen—inspiring Tim was first diagnosed with multiple sclerosis (MS) in 1975 Yet, he continued a remarkable academic career of teaching and research In 1996, he published the first edition of his principles of economics textbook to great acclaim, and it became widely used in colleges around the country That same year, MS made him wheelchair-bound The disease forced his retirement from teaching at the University of Colorado at Colorado Springs in 1998 He lost the use of his arms in 2001 and has been quadriplegic ever since In 2002, Tim’s doctor expected him to die About the Authors He was placed in the Pikes Peak Hospice program and was twice given his last rites by his priest UCCS Chancellor Shockley-Zalabak says, “I really thought that Tim would die in hospice That’s what the doctors told me, and I really believed that I remember one day they called me and told me to try to come see him They didn't expect him to live through the night.” Not only did he live through the night, but he eventually recovered to the point that he moved from hospice to a long-term care facility There, he never let his disease get him down In fact, he turned back to his love of writing and teaching for inspiration He obtained a voice-activated computer, recruited a coauthor, Libby Rittenberg of Colorado College, and turned his attention to revising his principles of economics book Unnamed Publisher is honored to publish a new, first edition relaunch of this wonderful book, and proud to bring Tim’s incredible talents as a teacher back to life for future generations of students to learn from In addition to completing the rewrite of his textbook, Tim recently completed an autobiography about the thirty-two years he has had MS, titled Suffering, Faith, and Wildflowers He is nearing completion of a novel, Cool Luck, based on the life of a friend It is the story of a young couple facing the husband’s diagnosis of ALS—Lou Gehrig’s disease Remarkably, in 2007, he was able to return to the classroom at UCCS, where he had taught economics for twenty-seven years In January of 2009, Tim married Dinora Montenegro (now Dinora Tregarthen); the couple lives in San Gabriel, California Perhaps Tim’s approach to life is best summed up by an observation by UCCS English Professor Thomas Naperierkowski: “One of the remarkable things is, heck, I can wake up with a headache and be a pretty grouchy character, but given his physical trials, which he faces every minute of his life these days, I’ve never seen him grouchy, I’ve never seen him cranky.” Carry on, Tim Acknowledgments The authors would like to thank to the following individuals who reviewed the text and whose contributions were invaluable in shaping the final product: Carlos Aguilar El Paso Community College Jeff Ankrom Wittenberg University Lee Ash Skagit Valley Community College Randall Bennett Gonzaga University Joseph Calhoun Florida State University Richard Cantrell Western Kentucky University Gregg Davis Flathead Valley Community College Kevin Dunagan Oakton Community College Mona El Shazly Columbia College Jose Esteban Palomar College Maurita Fawls Portland Community College Fred Foldvary Santa Clara University Richard Fowles University of Utah Doris GeideStevenson Weber State University Sarmila Ghosh University of Scranton, Kania School of Management David Gordon Illinois Valley Community College Clinton Greene University of Missouri-St Louis James Holcomb University of Texas at El Paso Phil Holleran Mitchell Community College Yu Hsing Southeastern Louisiana University Thomas Hyclak Lehigh University Bruce Johnson Centre College James Kahiga Georgia Perimeter College Andrew Kohen James Madison University Acknowledgments Monaco Kristen California State University–Long Beach Mark Maier Glendale Community College David McClough Bowling Green State University Ann McPherren Huntington University John Min Northern Virginia Community College Shahriar Mostashari Campbell University, Lundy-Fetterman School of Business Francis Mummery Fullerton College Robert Murphy Boston College Kathryn Nantz Fairfield University Paul Okello Tarrant County College-South Campus Nicholas Peppes St Louis Community College Ramoo Ratha Diablo Valley College Teresa Riley Youngstown State University Michael Robinson Mount Holyoke College Anirban Sengupta Texas A&M University John Solow The University of Iowa John Somers Portland Community College Charles Staelin Smith College Richard Stratton The University of Akron Kay E Strong Bowling Green State University–Firelands Della Sue Marist College John Vahaly University of Louisville Robert Whaples Wake Forest University Mark Wheeler Western Michigan University Leslie Wolfson The Pingry School Sourushe Zandvakili University of Cincinnati We would like to extend a special thank you to the following instructors who class tested the text in their courses: Chapter 21 Appendix A: Graphs in Economics region of the curve? Where would you guess the United States is? Japan? Does the Magee curve seem plausible to you? Draw graphs showing the likely relationship between each of the following pairs of variables In each case, put the first variable mentioned on the horizontal axis and the second on the vertical axis The amount of time a student spends studying economics and the grade he or she receives in the course Per capita income and total expenditures on health care Alcohol consumption by teenagers and academic performance Household income and the likelihood of being the victim of a violent crime 21.3 Using Graphs and Charts to Show Values of Variables 889 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model In this appendix, we will extend the aggregate expenditures model in two ways First, we will express the model in general algebraic form and show how to solve it for the equilibrium level of real GDP The advantage of using general algebraic expressions in place of the specific numbers that we used in the chapter is that we can then use the results to solve for any specific value that may pertain to a given economy Second, we will show how the aggregate expenditures model can be used to analyze the impact of fiscal policies on the economy 890 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model 22.1 The Algebra of Equilibrium Suppose an economy can be represented by the following equations: Equation 22.1 C = Ca + bY d Equation 22.2 T = T a + tY Equation 22.3 Ip = Ia Equation 22.4 G = Ga Equation 22.5 X n = X na As in our specific example in the chapter, the consumption function given in Equation 22.1 has an autonomous component (Ca) and an induced component (bYd), where b is the marginal propensity to consume (MPC) In the example in the chapter, Ca was $300 billion and the MPC, or b, was 0.8 Equation 22.2 shows that total taxes, T, include an autonomous component Ta (for example, property taxes, licenses, fees, and any other taxes that not vary with the level of income) and an induced component that is a fraction of real GDP, Y That fraction is the tax rate, t Disposable personal income is just the difference between real GDP and total taxes: Equation 22.6 Ya = Y − T In Equation 22.3, Equation 22.4, and Equation 22.5, Ia, Ga, and X na are specific values for the other components of aggregate expenditures: investment (Ip), government 891 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model purchases (G), and net exports (Xn) In this model, planned investments, government purchases, and net exports are all assumed to be autonomous For this reason, we add the subscript “a” to each of them We use the equations that describe each of the components as aggregate expenditures to solve for the equilibrium level of real GDP The equilibrium condition in the aggregate expenditures model requires that aggregate expenditures for a period equal real GDP in the period We specify that condition algebraically: Equation 22.7 Y = AE Aggregate expenditures AE consist of consumption plus planned investment plus government purchases plus net exports We thus replace the right-hand side of Equation 22.7 with those terms to get Equation 22.8 Y = C + Ip + G + X n Consumption is given by Equation 22.1 and the other components of aggregate expenditures by Equation 22.3, Equation 22.4, and Equation 22.5 Inserting these equations into Equation 22.8, we have Equation 22.9 Y = Ca + bY d + Ia + Ga + X n a We have one equation with two unknowns, Y and Yd We therefore need to express Yd in terms of Y From Equation 22.2 and Equation 22.6, we can write Y d = Y − (T a + tY) And remove the parentheses to obtain Equation 22.10 Y d = Y − T a − tY 22.1 The Algebra of Equilibrium 892 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model We then factor out the Y term on the right-hand side to get Equation 22.11 Y d = (1 − t) Y − T a We now substitute this expression for Yd into Equation 22.9 to get Y = Ca + b [(1 − t) Y − T a ] + Ia + Ga + X n a Equation 22.12 Y = Ca − bT a + b (1 − t) Y + Ia + Ga + X n a The first two terms (Ca − bTa) show that the autonomous portion of consumption is reduced by the marginal propensity to consume times autonomous taxes For example, suppose Ta is $10 billion If the marginal propensity to consume is 0.8, then consumption is $8 billion less than it would have been if Ta were zero Combining the autonomous terms in Equation 22.12 in brackets, we have Equation 22.13 Y = [Ca − b (T a ) + Ia + Ga + X n a ] + b (1 − t) (Y) ⎯⎯⎯ Letting A stand for all the terms in brackets, we can simplify Equation 22.13: Equation 22.14 ⎯⎯⎯ Y = A + b (1 − t) Y The coefficient of real GDP (Y) on the right-hand side of Equation 22.14, b(1 − t), gives the fraction of an additional dollar of real GDP that will be spent for consumption: it is the slope of the aggregate expenditures function for this representation of the economy The aggregate expenditures function for the simplified economy that we presented in the chapter has a slope that was simply the marginal propensity to consume; there were no taxes in that model, and disposable personal income and real GDP were assumed to be the same Notice that in using this more realistic aggregate expenditures function, the slope is less by a factor of (1 − t) 22.1 The Algebra of Equilibrium 893 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model We solve Equation 22.14 for Y: ⎯⎯⎯ Y − b (1 − t) (Y) = A ⎯⎯⎯ Y [1 − b (1 − t)] = A Equation 22.15 Y= ⎯⎯⎯ (A ) − b (1 − t) In Equation 22.15, 1/[1 − b(1 − t)] is the multiplier Equilibrium real GDP is achieved at a level of income equal to the multiplier times the amount of autonomous spending Notice that because the slope of the aggregate expenditures function is less than it would be in an economy without induced taxes, the value of the multiplier is also less, all other things the same In this representation of the economy, the value of the multiplier depends on the marginal propensity to consume and on the tax rate The higher the tax rate, the lower the multiplier; the lower the tax rate, the greater the multiplier For example, suppose the marginal propensity to consume is 0.8 If the tax rate were 0, then the multiplier would be If the tax rate were 0.25, then the multiplier would be 2.5 22.1 The Algebra of Equilibrium 894 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model 22.2 The Aggregate Expenditures Model and Fiscal Policy In this appendix, we use the aggregate expenditures model to explain the impact of fiscal policy on aggregate demand in more detail than was given in the chapter on government and fiscal policy As we did in the chapter, we will look at the impact of various types of fiscal policy changes The possibility of crowding out was discussed in the fiscal policy chapter and will not be repeated here Changes in Government Purchases All other things unchanged, a change in government purchases shifts the aggregate expenditures curve by an amount equal to the change in government purchases A $200-billion increase in government purchases, for example, shifts the aggregate expenditures curve upward by $200 billion A $75-billion reduction in government purchases shifts the aggregate expenditures curve downward by that amount Panel (a) of Figure 22.1 "An Increase in Government Purchases" shows an economy that is initially in equilibrium at an income of $7,000 billion Suppose that the slope of the aggregate expenditures function (that is, b[1 − t]) is 0.6, so that the multiplier is 2.5 An increase of $200 billion in government purchases shifts the aggregate expenditures curve upward by that amount to AE2 In the aggregate expenditures model, real GDP increases by an amount equal to the multiplier times the change in autonomous aggregate expenditures Real GDP in that model thus rises by $500 billion to a level of $7,500 billion Figure 22.1 An Increase in Government Purchases 895 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model The economy shown here is initially in equilibrium at a real GDP of $7,000 billion and a price level of P1 In Panel (a), an increase of $200 billion in the level of government purchases shifts the aggregate expenditures curve upward by that amount to AE2, increasing the equilibrium level of income in the aggregate expenditures model by $500 billion In Panel (b), the aggregate demand curve thus shifts to the right by $500 billion to AD2 The equilibrium level of real GDP rises to $7,300 billion, while the price level rises to P2 The aggregate expenditures model, of course, assumes a constant price level To get a more complete picture of what happens, we use the model of aggregate demand and aggregate supply In that model shown in Panel (b), the initial price level is P1, and the initial equilibrium real GDP is $7,000 billion That is the price level assumed to hold the aggregate expenditures model The $200-billion increase in government purchases increases the total quantity of goods and services demanded, at a price level of P1 by $500 billion The aggregate demand curve thus shifts to the right by that amount to AD2 The equilibrium level of real GDP, however, only rises to $7,300 billion, and the price level rises to P2 Part of the impact of the increase in aggregate demand is absorbed by higher prices, preventing the full increase in real GDP predicted by the aggregate expenditures model A reduction in government purchases would have the opposite effect All other things unchanged, aggregate expenditures would shift downward by an amount equal to the reduction in aggregate purchases In the model of aggregate demand and aggregate supply, the aggregate demand curve would shift to the left by an amount equal to the initial change in autonomous aggregate expenditures times the multiplier Real GDP and the price level would fall The fall in real GDP is less than would occur if the price level stayed constant In the remainder of this appendix, we will focus on the shift in the aggregate expenditures curve To determine what happens to equilibrium real GDP and the price level, we must look at the intersection of the new aggregate demand curve and the short-run aggregate supply curve, as we did in Panel (b) of Figure 22.1 "An Increase in Government Purchases" Change in Autonomous Taxes A change in autonomous taxes shifts the aggregate expenditures in the opposite direction of the change in government purchases If the autonomous taxes go up, for example, aggregate expenditures go down by a fraction of the change Because the initial change in consumption is less than the change in taxes (because it is multiplied by the MPC, which is less than 1), the shift caused by a change in taxes is less than an equal change (in the opposite direction) in government purchases 22.2 The Aggregate Expenditures Model and Fiscal Policy 896 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model Now suppose that autonomous taxes fall by $200 billion and that the marginal propensity to consume is 0.8 Then the shift up in the aggregate expenditures curve is $160 billion (= 0.8 × $200) As we saw, a $200-billion increase in government purchases shifted the aggregate expenditures curve up by $200 billion Assuming a multiplier of 2.5, the reduction in autonomous taxes causes equilibrium real GDP in the aggregate expenditures model to rise by $400 billion This is less than the change of $500 billion caused by an equal (but opposite) change in government purchases The impact of a $200-billion decrease in autonomous taxes is shown in Figure 22.2 "A Decrease in Autonomous Taxes" Figure 22.2 A Decrease in Autonomous Taxes A decrease of $200 billion in autonomous taxes shifts the aggregate expenditures curve upward by the marginal propensity to consume of 0.8 times the changes in autonomous taxes of $200 billion, or $160 billion, to AE2 The equilibrium level of income in the aggregate expenditures model increases by $400 billion to $7,400 billion All figures are in billions of base-year dollars Similarly, an increase in autonomous taxes of, for example, $75 billion, would shift the aggregate expenditures curve downward by $60 billion (= 0.8 × $75) and cause the equilibrium level of real GDP to decrease by $150 billion (= 2.5 × $60) 22.2 The Aggregate Expenditures Model and Fiscal Policy 897 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model Changes in Income Tax Rates Changes in income tax rates produce an important complication that we have not encountered thus far When government purchases or autonomous taxes changed, the aggregate expenditures curve shifted up or down The new aggregate expenditures curve had the same slope as the old curve; the multiplier was the same before and after the change in government purchases or autonomous taxes When income tax rates change, however, the aggregate expenditures curve will rotate, that is, its slope will change As a result, the value of the multiplier itself will change We saw in the first section of this appendix that when taxes are related to income, the multiplier depends on both the marginal propensity to consume and the tax rate An increase in income tax rates will make the aggregate expenditures curve flatter and reduce the multiplier A higher income tax rate thus rotates the aggregate expenditures curve downward Similarly, a lower income tax rate rotates the aggregate expenditures curve upward, making it steeper Suppose that an economy with an initial real GDP of $7,000 billion has an income tax rate of 0.25 To simplify, we will assume there are no autonomous taxes (that is, Ta = 0) So T = tY Thus, disposable personal income Yd is 75% of real GDP: Equation 22.16 T = 0.25Y Equation 22.17 Y a = Y − T = 0.75Y Suppose the marginal propensity to consume is 0.8 A $1 change in real GDP produces an increase in disposable personal income of $0.75, and that produces an increase in consumption of $0.60 (= 0.8 × 0.75 × $1) If the other components of aggregate expenditures are autonomous, then the multiplier is 2.5 (= / [1 − 0.6]) The impact of a tax rate change is illustrated in Figure 22.3 "The Impact of an Increase in Income Tax Rates" It shows the original aggregate expenditures curve AE1 intersecting the 45-degree line at the income of $7,000 billion The curve has a slope of 0.6 Now suppose that the tax rate is increased to 0.375 The higher tax rate will rotate this curve downward, making it flatter The slope of the new aggregate 22.2 The Aggregate Expenditures Model and Fiscal Policy 898 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model expenditures curve AE2 will be 0.5 (= − 0.8[1 − 0.375]) The value of the multiplier thus falls from 2.5 to (= / [1 − 0.5]) Figure 22.3 The Impact of an Increase in Income Tax Rates An increase in the income tax rate rotates the aggregate expenditures curve downward by an amount equal to the initial change in consumption at the original equilibrium value of real GDP found in the aggregate expenditures model, $7,000 billion in this case, assuming no other change in aggregate expenditures It reduces the slope of the aggregate expenditures curve and thus reduces the multiplier Here, an increase in the income tax rate from 0.25 to 0.375 reduces the slope from 0.6 to 0.5; it thus reduces the multiplier from 2.5 to The higher tax reduces consumption by $700 billion and reduces equilibrium real GDP in the aggregate expenditures model by $1,400 billion At the original level of income, $7,000 billion, tax collection equaled $1,750 billion (again, for this example, we assume Ta = 0, so T = 0.25 × $7,000) At the new tax rate and original level of income, they equal $2,625 billion (0.375 × $7,000 billion) Disposable personal income at a real GDP of $7,000 billion thus declines by $875 billion With a marginal propensity to consume of 0.8, consumption drops by $700 billion (= 0.8 × $875 billion) The aggregate expenditures curve rotates down by this amount at the initial level of income of $7,000 billion, assuming no other changes in aggregate expenditures occur 22.2 The Aggregate Expenditures Model and Fiscal Policy 899 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model Before the tax rate increase, an additional $1 of real GDP induced $0.60 in additional consumption At the new tax rate, an additional $1 of real GDP creates $0.625 in disposable personal income ($1 in income minus $0.375 in taxes) Given a marginal propensity to consume of 0.8, this $1 increase in real GDP increases consumption by only $0.50 (= [$1 × (0.8 × 0.625)]) The new aggregate expenditures curve, AE2 in Figure 22.3 "The Impact of an Increase in Income Tax Rates", shows the end result of the tax rate change in the aggregate expenditures model Its slope is 0.5 The equilibrium of the level of real GDP in the aggregate expenditures model falls to $5,600 billion from its original level of $7,000 The $1,400-billion reduction in equilibrium real GDP in the aggregate expenditures model is equal to the $700-billion initial reduction in consumption (at the original equilibrium level of real GDP) times the new multiplier of The tax rate increase has reduced aggregate expenditures and reduced the multiplier impact of this change (from 2.5 to 2) The aggregate demand curve will shift to the left by $1,400 billion, the new multiplier times the initial change in aggregate expenditures In the model of aggregate demand and aggregate supply, a tax rate increase will shift the aggregate demand curve to the left by an amount equal to the initial change in aggregate expenditures induced by the tax rate boost times the new value of the multiplier Similarly, a reduction in the income tax rate rotates the aggregate expenditures curve upward by an amount equal to the initial increase in consumption (at the original equilibrium level of real GDP found in the aggregate expenditures model) created by the lower tax rate It also increases the value of the multiplier Aggregate demand shifts to the right by an amount equal to the initial change in aggregate expenditures times the new multiplier 22.2 The Aggregate Expenditures Model and Fiscal Policy 900 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model 22.3 Review and Practice 901 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model NUMERICAL PROBLEMS Suppose an economy is characterized by the following equations All figures are in billions of dollars C = 400 + ⅔(Yd) T = 300 + ¼(Y) G = 400 I = 200 Xn = 100 a Solve for the equilibrium level of income b Now let G rise to 500 What happens to the solution? c What is the multiplier? Consider the following economy All figures are in billions of dollars C = 180 + 0.8(Yd) T = 100 + 0.25Y I = 300 G = 400 Xn = 200 a Solve for the equilibrium level of real GDP b Now suppose investment falls to $200 billion What happens to the equilibrium real GDP? c What is the multiplier? Suppose an economy has a consumption function C = $100 + ⅔ Yd Autonomous taxes, Ta, equal 0, the income tax rate is 10%, and Yd 22.3 Review and Practice 902 Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model = 0.9Y Government purchases, investment, and net exports each equal $100 Solve the following problems a Draw the aggregate expenditures curve, and find the equilibrium income for this economy in the aggregate expenditures model b Now suppose the tax rate rises to 25%, so Yd = 0.75Y Assume that government purchases, investments, and net exports are not affected by the change Show the new aggregate expenditures curve and the new level of income in the aggregate expenditures model Relate your answer to the multiplier effect of the tax change c Compare your result in the aggregate expenditures model to what the aggregate demand–aggregate supply model would show Suppose a program of federally funded public-works spending were introduced that was tied to the unemployment rate Suppose the program were structured so that public-works spending would be $200 billion per year if the economy had an unemployment rate of 5% at the beginning of the fiscal year Public-works spending would be increased by $20 billion for each percentage point by which the unemployment rate exceeded 5% It would be reduced by $20 billion for every percentage point by which unemployment fell below 5% If the unemployment rate were 8%, for example, public-works spending would be $260 billion How would this program affect the slope of the aggregate expenditures curve? 22.3 Review and Practice 903 ... majors with more than 2 200 students taking the test to enter law school in the 200 3– 200 4 academic year Source: Michael Nieswiadomy, “LSAT Scores of Economics Majors: 200 3– 200 4 Class Update,” Journal... Undergraduate Majors Major field LSAT average 200 3– 200 4 200 3– 200 4 Rank 1994–1995 Rank 1991–1992 Rank Economics 156.6 1 Engineering 155.4 History 155 .0 3 English 154.3 4 Finance 152.6 Political science... Occupation 200 4– 201 4 Computer Engineering $54, 200 10. 1 Electrical/Electronic Engineering 54 ,05 3 11.8 Computer Science 50, 892 25.6 Accounting 46,188 22.4 Economics and Finance 45 ,05 8 12.4 Management