Macroeconomics

Macro Economics

Macro Economics

Section A

1. The open economy multiplier with a proportional tax is smaller than the multiplier

with a lump-sum tax. Therefore, the slope of the IS curve with a proportional tax system will be steeper than its slope with a lump-sum tax system.

This statement is considered as true. Relaxing the assumption that taxes are a fixed amount per person and introducing a proportional tax system (i.e., taxes are a function of income), the size of the multiplier decreases, but a change in government spending will still have a multiplied effect on equilibrium output. For example, one can determine the change in equilibrium income if the government increases its spending by $100 billion when the mpc is 80% and taxes are 10% of income. Because taxes are a function of income, disposable income equals national income minus taxes (Rothbard, Murray, 1993). In this case, as the government increases its spending by $100 billion, income rises by $100 billion, but now households will have to pay 10% of the increase in income in taxes leaving an increase in disposable income of only $90 billion. With an mpc of 80%, this will induce an increase in consumption spending of $72 billion. When the rounds of spending and income when a 10% proportional tax is imposed then the total change in equilibrium income is $357 billion (or approximately $36 billion in taxes and $321 billion in disposable income) with an induced change in consumption of $257 billion. With the introduction of a 10% tax rate, the value of the multiplier fell to 3.57 from 5. With a proportional tax, the value of the multiplier can be calculated as

Multiplier= 1/(1-mpc + t*mpc)

This also explains why a proportional tax system is an automatic stabilizer for the economy. The introduction of the proportional tax system lowered the value of the multiplier. Anytime there is an exogenous change in any type of spending (i.e., consumption, private investment, or government spending), the change in equilibrium income will be smaller with proportional taxes than without, helping stabilize the economy.

Considering an open economy and small country Y = a + bY + I + X - mY

Y = (a + I + X)/(1 - b + m)

For instance, if b = 0.9, the multiplier is 10 in a closed economy. If m = 0.1, then it reduces to 5. Thus, the open economy multiplier is very sensitive to the marginal propensity to import.

2. By creating a surplus in the government budget while bringing about a surplus in

the Balance of Payments, the government will have brought about an increase in actual

investment.

This statement is partially true. This is an ongoing cycle that by creating a surplus in the government budget while bringing about a surplus in the Balance of Payments; the government will have brought about an increase in actual investment. Surplus can increase the future standard of living if they reduce consumption and increase national saving, whereby increasing the ...