Homework 5-

1. Complete the following table, and answer the questions that follow.

Taxes are proportional to income, so T = tY.  Assume that there are NO TRANSFERS.

Hint: You should consider using the slope formula to calculate MPC.

a) Determine the progressive tax rate t.

b) Determine the consumption and saving functions with respect to disposable income, and with respect to aggregate income.

c) Given the consumption function you determined in part (b), the tax rate you found in part (a), and the following information about the economy, determine the equilibrium output:

I = 130

G = 100 + .16T

X = 250

M = 200

d) Given equilibrium output, determine the equilibrium levels of consumption, savings, taxes, and government spending.

e) Is the government running a deficit or a surplus?  Are there capital inflows or outflows?

f) In terms of variables, determine the GDP multiplier.  Hint: you should model the equations as follows:

C = a + b(Y-T)

I = I

G = g + dT

X = X

M = M

T = tY

g) Determine the numerical value for the multiplier. Using the multipler, how much does GDP increase if autonomous consumption increases by 100?

h) Looking at your multiplier equation, what is the difference between the variables in the denominator of the multiplier and those which aren't (the variables that the multiplier is multiplying)? Is there any intuition which may explain this?

2. What are the three uses of money that were described in class?  Describe each of these uses (you can use a real world example for each if you'd like).

3. Suppose Jack Bauer deposits $250,000 in his account at Bank of America, and James Bond borrows $125,000 from Bank of America to buy an Aston Martin from the dealership. The required reserve ratio, set by the Federal Reserve, is 20%. The Aston Martin dealership deposits Mr. Bond's $125,000 into an account at the UW Credit Union. Assume that there are no currency drains.

a) What is a required reserve ratio (the definition, not the particular numerical value for this problem)? How is the required reserve ratio directly linked to the money multiplier?  If the required reserve ratio increases, what happens to the money multiplier?  Does this make sense?

b) Determine the money multiplier.  How much does Mr. Bauer's deposit increase the money supply (ignore the later effects of Mr. Bond's borrowing)?

c) Draw T-accounts for Bank of America, and UW Credit Union depicting the changes in assets and liabilities for these two institutions before any money multiplier expansion occurs.

d) What is the amount of required reserves held by Bank of America due to Mr. Bauer's deposit? What is the amount of required reserves held by UW Credit Union after the deposit from the Aston Martin dealership?  If you went to the UW Credit Union, and the only money they had was from the $125,000 deposit from the Aston Martin dealership, what is the MOST you could borrow from them?

e) If the Federal Reserve was to increase the required reserve ratio to 25%, what would the new money multiplier be?  Explain how a Federal Reserve policy like this can change the money supply.  What is your intuition about what will happen to interest rates in this scenario?