ec3102 t6 solutions

7/25/2019 EC3102 T6 Solutions

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Ho Kong WengPrepar ed by Pr of . Ho and di st r i but ed t o hi s TA s andst udent s f or t hei r benef i t s. Do not sel l t o, upl oad t o,or shar e wi t h t hi r d par t y or gani zat i ons or per sons.

NATIONAL UNIVERSITY OF SINGAPORE

Department of Economics

EC3102 Macroeconomic Analysis II

Prepared by Ho Kong Weng

Tutorial 6

Suggested answer to Question 1:

(a) Lower expected future interest rates, higher human and nonhuman wealth, and hence

higher consumption. Likewise, lower expected future interest rates, higher present value

of after-tax profits, and hence, and hence higher investment. Therefore, current private

spending increases. The IS curve shifts to the right.

(b) First, an increase in expected future taxes tends to reduce expected future after-tax

income (for any given level of income), and therefore to reduce consumption. Inother words, human wealth is reduced and consumption falls. This effect tends to shift

the IScurve to the left.

Second, the increase in future taxes (a deficit reduction program) tends to reduce real

interest rates in the future. The fall in the expected future interest rate tends to shift

the IS curve to the right because both human and nonhuman wealth are raised. See

the suggested answer to (a).

Third, and related to the above, a fall in the real interest rate in the future will increase

the present-value of after-tax profits, boosting investment. The IS curve will shift to

the right.

The following diagram is a good guide to the effects:

The net effect on the IScurve is ambiguous. Note that the basic model of the lecture

and textbook has lump sum taxes. If taxes are not lump sum, the tax increase may


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increase distortions in the economy. These effects tend to reduce output (or the

growth rate).

(c) A decrease in expected future income, either labor income, or dividend income, will

reduce human wealth, or nonhuman wealth, implying lower consumption and

investment. Therefore, current private spending decreases. The IS curve shifts to the left.

Suggested answer to Question 2:

(a) In the medium run, budget deficit reduction will lead to higher savings and higher

investment. Real interest rate is lowered in the medium run.

Point to ponder: In the medium run, how is the composition of output changed given

a budget deficit reduction? Hint: Check your answers for earlier tutorials.

In the long run, higher investment is translated to capital accumulation, higher capital

stock and hence higher output.

(b) Brief review: A cut in G will shift the current IS curve to the left; expected future

output increases and shift the current IS curve to the right; expected future real

interest rates go down and shift the current IS curve to the right. The combined effects

have an ambiguous impact on the net shift of the current IS curve.

Advantage: Backloading the budget reduction program toward the future may make the

leftward shift of the current IS curve small, and make the rightward shift of the current

IS curve big. Current output is more likely to increase as a result.

Disadvantage: Backloading may reduce the credibility of the program to cut

governments budget deficit in the future when the current cut, like a signal, is very

small. A loss in credibility will reduce the magnitude of the expected increase in future

output and the expected fall in future real interest rates.

(c) The gesture seemed to indicate that the Fed supported deficit reduction, and was

willing to conduct expansionary monetary policy in the future to offset the direct


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negative effects on output from spending cuts and tax increases. A belief that the Fed

was willing to act in this way would tend to increase expected future output (relative

to the case where the Fed did nothing) and to reduce expected future interest rates.

Both of these effects would tend to increase output in the short-run or the present.

ec3102 t6 solutions

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