a.What is the short-run equilibrium output for FarFarAway? Please show your calculation.

b.Briefly explain how the government of FarFarAway can change from the short-run equilibrium output (i.e. your answer to (a)) to the potential output using fiscal policy. In your answer, please state only one tool that the government can use to implement this policy and explain how it can affect output.

Answer

The short run equilibrium output is the output level at which Y = AE, which AE is the sum of consumption (C), private investment ( I ), government expenditure (G) and Net export (NX).

The equation Y = 1000+0.8(Y-T) + 2000-1000r +2000 + 90 will be obtained. Given in the question, the income taxes is T = tY. This can be substituted into the consumption function.

The equation is as follow:

Y = 1000+0.8(Y-T) + (2000-1000r) +2000 + 90

Y = 5090 + 0.8(Y-tY) -1000r

Y = 5090 + 0.8(Y-tY) -1000(0.05)

Y = 5040 + 0.8(Y-0.2Y)

Y = 5040 + 0.64 Y

Y = 14000

Therefore, the short run equilibrium output is 14000.

b. We can change from the short-run equilibrium output 14000 to the potential output 15000 using expansionary fiscal policy, which aims at increasing the short-run equilibrium output.

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There are two tools that the government can use. The first one is to increase the government expenditure. The second one is to decrease taxes. Refer to the question, only one tool that the government can use to implement this policy. So to increase government expenditure should be used.

The increase in government expenditure can lead to an increase in aggregate demand such that the aggregate demand curve shifts to the right. At this new equilibrium, both the equilibrium price level and the equilibrium output increase. Therefore, increasing the government expenditure can achieve potential output.

Suppose the government increases spending by 100, that is from 2000 to 2100, on education such that the new value of G = 2100. At Equilibrium,

AE = Y,

Y= 5140 + 0.64Y

Y= 14277.78

So the equilibrium output Y = 14278. But the change in equilibrium output is equal to (14278-14000) = 278, which is much larger than the increase in the actual government spending 100.

This process includes two steps. At first, the government expenditure increases by 100 and the equilibrium output also goes up by 100. But then, the consumption goes up by 64 with the increase in 100 of the equilibrium output. Therefore, we can conclude that the overall change in equilibrium depends on the size of the multiplier.

8.2The following table shows the planned expenditure of Country A at various levels of real GDP. This country’s potential real GDP is 220. The current personal income tax rate is 20 percent.

Real GDP,

YPrivate

consumption,

CPrivate

investment,

IGovernment spending,

G

Net export,

NXBudget deficit,

G minus T

50325040330

100645040-420

150965040-1110

2001285040-180

2501605040-25-10

a.If this country is currently at equilibrium, what is the value of its real GDP? What is the government’s budget deficit position? What is the value of the output gap? Briefly explain your answer.

c.Suppose the government of Country A in part (a) would like to eliminate the output gap, can you suggest one possible fiscal policy that can help the government of Country A to achieve its target? Briefly explain how your suggested policy can eliminate the output gap.

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Real GDP,

YPrivate

consumption,

CPrivate

investment,

IGovernment spending,

G

Net export,

NXBudget deficit,

G minus TAggregate planned expenditure AE

(C+I+G+NX)

50325040330125

100645040-420150

150965040-1110175

2001285040-180200

2501605040-25-10225

Answer

a.The aggregate planned expenditure should be first calculated.

The value of the real GDP:

The planned expenditure should be equal to the actual expenditure whe Country A is at equilibrium. Refer to the table above, the aggregate expenditure is equal to the real GDP when it is 200. So in equilibrium, the value of real GDP should be 200.

### The government’s budget deficit position:

The government’s deficit budget is 0 when the aggregate expenditure and the real GDP are both at 200. It means that the government expenditure is equal to the tax revenue. So the government actually has a balanced budget.

Value of output gap:

Output gap = Actual real GDP – Potential GDP

So the value of the output gap is

= 200-220

= -20

b.

To eliminate output gap, the government of country A should increase the government spending to achieve its target. GDP multiplier needs to be found to find out the value to be increased in terms of government spending.

GDP multiplier = Change in equilibrium real GDP/ Amount changed in AE = (250

– 200) / (225 – 200)

= 50 / 25

= 2

So the GDP multiplier is 2. The required change in government spending = the required change in equilibrium real GDP / GDP multiplier = 20 /2 = 10

Therefore the government in Country A should increase the government spending by 10 in order to eliminate the output gap.