Columbia College

Economics 3213

Professor Xavier Presents

Problem Set 10

(1)  Cruella DeVil 

In what follows, you can assume that public spending is NOT productive.

Using the Classical Model:

(a) Assuming that taxes are lump sum, evaluate the effect of a permanent reduction of public spending and a similar reduction in lump sum taxes on output, the real interest rate and the price level. Can you say anything about whether people will like this policy of a smaller government spending? Why don't governments reduce spending in the real world?

(b) Imagine instead that the president and the congress agree on a reduction, but only for one year.

(c) Imagine now that the government announces today (period 1) that they will reduce spending in period 2 (and will reduce taxes in period 2). Spending and taxes in period 1 will not change, and spending and taxes in periods 3, 4, and all future periods will remain the same. What will be the effects on output, consumption, investment, labor supply, the interest rate and the price level TODAY?

(2) Nanny

Use the Keynesian model to answer Question 1. Are your answers different? Why?

(3) Pongo and Perdy

The popular press always says that deficits are "bad" for the economy.

(a) Why do they say deficits are bad?

Consider a reduction in T₁ of 1 billion dollars financed with a deficit. Imagine that this deficit and the interests that it generates will be financed by tax increases in period 2 (assume that taxes are lump sum). All future taxes and debts remain the same, and no spending ever changes.

(b) Consider a world in which people are Liquidity Constrained (Keynesian Model). What would be the effect ON OUTPUT of the experiment above? Why would that be bad?

(c) Consider the effects on the economy of the same experiment as before in the classical model where everyone can borrow and lend as much as they want. If the interest rate is r=0.10 (10%), by how much will consumption change? By how much will private savings change? What is the difference between (b) and (c)? Why?

(4) Horace and Jasper

Imagine now that the deficit created by the reduction in T₁ will be financed ENTIRELY by a reduction in spending in period 2 (in other words, T₂ will remain the same but g₂ will decline). All future deficits and spendings after period 2 remain the same. Note that g₁ does not change.

(a) Analyzing the government's budget constraint, by how much will g₂ have to decline (assume that the interest is r=0.10)?

(b) What will be the effect of all this on output, consumption, investment and the interest rate IN THE KEYNESIAN MODEL?

(c) What will be the effect of all this on output, consumption, investment and the interest rate IN THE CLASSICAL MODEL?

(d) Do deficits ever matter in the classical model? What is the difference between (3c) and (4c)?

(5) Roger and Anita...and Pongo and Perdy

(a) Use the classical model to analyze the behavior of r, Y, C, I, and P when the government permanently introduces a budget SURPLUS. That is, the government increases lump sum taxes in period 1, and introduces a tax cut in period to so as to keep all government spending in all periods unchanged AND all future taxes after next period unchanged.

(b) What is the behavior of the macroeconomy if the government does what we asked in (a) BUT some agents are liquidity constrained?

(c) Imagine now that, in the classical model, the government increases spending in period 1 and finances this increase in spending, not with an increase in taxes but with a the fiscal deficit which, in turn, will be paid off in full (that is, with interest) in period 2. What are the effects on the macroeconomy? (HINT: an increase in G₁ financed with a deficit is equivalent to an increase in G₁ financed with an increase in T₁ PLUS a decrease in T₁ by the same amount along with an increase in T₂ by that amount times (1+r)).