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Course:- Macroeconomics
Reference No.:- EM13434

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Assignment Help >> Macroeconomics

Changes in government spending and interest rates.

Government spending is given by the equations:

Recall that current government spending is a fraction Φ of current output. Suppose now that Φ is drawn randomly each period (sometimes the government needs a lot of resources other times it doesn't). Specifically, we will assume that Φ is uniformly distributed between [.17 and .23] (it has an average of .2). Set s = .2, δ = .1, α = .35  and A = .10

a.) Calculate steady state capital, (K*), output (Y*) and consumption (C*) assuming Φ = .2.

If consumers had "standard" preferences, the tangency conditions would imply

ct+1/ct = 1+ri

Since the interest rate is set before future consumption is realized, consumers have only expectations for ct+1. Assume consumers expect ct+1 to be equal to the steady state level of consumption C*. As a result, the real interest rate will satisfy:

b.) Redo the spreadsheet program but create new columns for Φt, ct and (1 + rt). To have Excel draw random numbers between .17 and .23 type " = .17 + rand()*.06 " (note: Excel will redraw random numbers each time you hit enter or delete so don't get too attached to any one simulation). Plot out one simulation (e.g, plot Y, I and G).

c.) Add another column and calculate the % difference between 1+rt and the steady state value of 1+r (which is 1). Also calculate the % differences between Gt and the steady state value of G (which is .2Y*). These series are:

Plot these series (plot out 20 periods or so). What is the relationship between Gt and rt? Does this make sense?

2. IS/LM and Forward Looking Consumers.

The normal IS relationship is derived from the goods market clearing condition:

However, we know from our simple 2-period dynamic optimizing models that consumption does not just depend on current disposable income (Y -T), rather, the consumption function we used says that C = C (W- , Y - T, r) so that the IS relationship should be

This is useful because it implies that expectations about future taxes and income (as they are incorporated into W and ) will affect C now.

Assuming that Ricardian Equivalence does not hold, use the IS/LM model with the modifications described above to describe how the following events would affect Y, C, I, and r.

a.) The President passes a "phased in" tax cut that will go into effect after a year.

b.) The public expects a substantial increase in government spending in the future.

c.) Consider the following two tax policies:

(A) raises taxes by ΔT this year but then returns taxes back to normal in the future.

(B) raises taxes permanently by ΔT.

Will these policies affect Aggregate Demand differently? How?