Problem Set # 2

This problem set is due Thursday, November 2, at the beginning of the class period. Problem sets done on notebook paper or unstapled will not be accepted. Late problem sets are unacceptable also.

1. You are given the following information about the U.S. economy: When unemployment is at its natural rate, which is 6 percent, government spending is 22 percent of GDP, while taxes and other government revenues are equal to 14 percent of GDP. For each 1 percentage point increase in the unemployment rate, government spending increases by 1 percentage point of GDP and taxes fall by 2 percentage points of GDP. There is no inflation.

a) In 1995, the unemployment rate is 6%. Calculate the actual, structural, and cyclical deficits (as percentages of GDP) of the U.S. government.

b) In 1996, the unemployment rate is 7%. Calculate the actual, structural, and cyclical deficits (as percentages of GDP) of the U.S. government.

c) In 1997, the unemployment rate is 9%. Calculate the actual, structural, and cyclical deficits (as percentages of GDP) of the U.S. government.

d) In 1998, the U.S. Congress and the Administration decide to cut taxes and increase government expenditures to stimulate the economy. Now you are told that when unemployment is 6 percent, government spending is 25 percent of GDP, while taxes and other government revenues are equal to 12 percent of GDP. Furthermore, as happened before, for each 1 percentage point increase in the unemployment rate, government spending increases by 1 percentage point of GNP and taxes fall by 2 percentage points of GDP. Assuming that these policies make the unemployment rate fall to 7%, calculate the actual, structural, and cyclical deficits (as percentages of GDP) of the U.S. government.

e) In 1999, the unemployment rate is 6%. Calculate the actual, structural, and cyclical deficits (as percentages of GDP) of the U.S. government (Assume that the changes that took place in 1998 are permanent).

2. In 1995 China has a large foreign trade surplus (or positive net exports).

a) Draw a diagram representing the Chinese economy during 1995 (Hint: In this diagram, equilibrium output must occur at a level in which net exports are positive; and this should be shown in your diagram).

b) Assume that the Chinese government wants to reduce the trade surplus without changing the level of national output. Describe the changes in fiscal policy and in the exchange rate that would be necessary to achieve these objectives. Use a diagram to show the effects of your proposed policy changes.

3. You are given the following information about Luniz's economy:

Each year consumers spend $3,000 million regardless of the level of their disposable income. In addition to those $3,000 million, they always spend 90% of their yearly disposable income.

Investment is fixed at $2,500 million.

Government expenditures are $1,500 million.

Net taxes equal $1,700 million.

Exports are $3,000 million.

Imports are always equal to 1,000 million plus 15% of the level of disposable income.

a) How much would Luniz's equilibrium level of output be?

b) How much would net exports be when this economy is at equilibrium output?

c) Luniz's main export product is Stackola. Due to new medical discoveries which prove that Stackola consumption reduces performance in economics exams, Luniz's exports fall by 750 million to a new level of $2,250 million. How much would Luniz's new equilibrium level of output be?

d) How much would net exports be when this economy is at its new equilibrium output?

e) Dr. Kay Novoselic, the President of Luniz, decides that she wants equilibrium output to go back to its original level. How much would she have to decrease taxes to achieve her objective?

f) How much would net exports be when the policies of Luniz's President bring equilibrium output back to its original level?

4. You are given the following information about Jodeci's economy:

Each year consumers spend $1,000 million regardless of the level of their disposable income. In addition to that $1,000 million, they always spend 80% of their yearly disposable income.

Investment is fixed at $1,500 million.

Government expenditures are $1,200 million.

Taxes equal 40% of income.

Exports are $460 million.

Imports are always equal $100 million plus 10% of the level of disposable income.

a) How much would Jodeci's equilibrium level of output be?

b) How much would net exports be when this economy is at equilibrium output?

c) How much would the net government surplus (or deficit) be when this economy is at equilibrium output?

d) Due to lack of confidence in the economy, Jodeci's investors decide to cut their investment level by $377 million to a new level of only $1,123 million. How much would Jodeci's new equilibrium level of output be?

e) How much would the net government surplus (or deficit) be when this economy is at its new equilibrium output? Was this change in the surplus (or deficit) due to structural or cyclical reasons? Explain.

f) Following supply-side ideas, and in order to stimulate the economy Jodeci's President, Dr. David Gahan, cuts taxes from 40% of income to a new level of only 25% of income. How much would Jodeci's new equilibrium level of output be?

g) Was Arthur Laffer's prediction that a cut in the tax rate would increase the government tax revenue correct in this case? Why or why not?