Econ2101 Review Question Week 6

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Question 1
(i) The government is considering two alternative policies, one involving increased government expenditure of $50 billion and the other involving a tax cut of $50 billion. Which policy is likely to increase planned aggregate expenditure by more? Explain. Use the AE model to illustrate your answer.

(ii) Explain the effect of a cut in the tax rate on an economy’s planned AE. Is the effect different from a cut in the exogenous component of taxation? See Bernanke Section 6.1 and 6.2.
The increase in government expenditure raises autonomous (or exogenous) planned aggregate expenditure by $10 billion. The tax cut raises disposable income by $10 billion, which also stimulates planned aggregate expenditure by raising consumption spending. However, the tax cut raises autonomous (exogenous) planned aggregate expenditure by only $10 billion times the marginal propensity to consume (MPC); since the MPC is less than one, the tax cut will increase autonomous (exogenous) planned aggregate expenditure by less than $10 billion. Thus the increase in government expenditure is predicted to have the greater impact on aggregate demand. Equation for PAE in 4-Sector Model

PAE = C + I
P
+ G + NX C = C − cT + c(1− t)Y M =−mT + m(1− t)Y NX = X − M (Lots of substitution and collecting terms gives)
PAE = [C − (c − m)T + I
P
+ G + X ] + (c − m)(1− t)Y
In this case a tax cut of $10 billion will raise PAE by the (smaller) amount of 10*(c‐m), not 10*c.
See Bernanke Section 6.2.
(ii) Note the use of the expression ‘tax rate’. This refers to the marginal income tax rate – that is, endogenous taxes. As the tax rate affects the slope of the planned aggregate expenditure line, an increase in the tax rate is quite different to an increase in the exogenous component of taxation. Specifically, an increase in the tax rate will reduce the slope of the planned aggregate expenditure line. An increase in the exogenous component of taxation will lead to a...
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