ANSWERS TO HOMEWORK WEEK FIVE EC141

CHAPTER 9 1. The debt starts at 1 million lavs at the end of year one and grows to 10 million lavs at the end of year ten. In year ten the interest on the debt will be 5% of the 10 million lavs: 500,000 lavs. Thus, government spending will be 10,500,000 lavs and taxes will be 9,000,000 lavs. [The key to the problem is that taxes are raised to cover the interest payments each year. Thus, the annual deficit remains at 1,000,000. If the interest was added to the expenditure side but taxes were not raised each year, the total debt would grow from 1 million to over 12.5 million and the interest payment would be 629,000 in year 10.] 7. (a) Equilibrium with government requires that output = spending, or that Y = C + I + G. Since we know that Y = C + S + T by definition, then equilibrium also requires that I + G = S + T. To see if Y = 200 is an equilibrium, add C + I + G to obtain 160 + 30 + 0 = 190. This is not an equilibrium because spending (190) is less than output (200). Alternatively, saving + taxes = 40 + 0 = 40, while investment + government spending = 30 + 0 = 30. Thus, S + T is not equal to I + G. (Notice that there is no autonomous consumption.) In the coming months, we can expect output (Y) to decline and workers to be laid off. Equilibrium Y = 150. At Y = 150, C + I + G = 0.8(150) + 30 + 0 = 150. (b) If $200 is the full-employment level of Y, the government would most likely follow an expansionary fiscal policy, cutting taxes and/or raising spending. In this case, an increase in spending would occur since taxes are currently zero. (c) If $250 is the full-employment level of Y, the government would most likely follow an expansionary fiscal policy, cutting taxes and/or raising spending. In this case, an increase in spending would occur since taxes are currently zero. (d) Equilibrium requires that Y = C + I + G = C + S + T. In this case, C + I + G = 160 + 40 + 0 = 200, and C + S + T = 160 + 40 + 0 = 200, so the economy is in equilibrium. (e) Equilibrium requires that Y = C + I + G = C + S + T. In this case, C + I + G = 160 + 40 + 30 = 230, and C + S + T = 160 + 40 + 0 = 200. Spending exceeds output (Y), so in coming months we can expect output (Y) to increase. In equilibrium, I + G = S + T, or 40 + 30 = S + 0, so the new level of S = 70. Since S = .2Y, Y = 350. C = .8Y, so C will equal 280. (f) Equilibrium requires that Y = C + I + G = C + S + T. In this case, C + I + G = 160 + 40 + 0 = 200, and C + S + T = 160 + 40 + 30 = 230. Spending is less than output (Y), so in coming months we can expect output (Y) to decrease. In equilibrium, I + G = S + T, or 40 + 0 = S + 30, so the new level of S = 10. Since S = .2Y, Y = 50. C = .8Y, so C will equal 40. In part (e), the government is stimulating the economy by increasing spending. In part (f), the government is slowing the economy by increasing taxes.

CHAPTER 10 1. (a) The debt increases by 5 million rags in total; the privately held debt increases by only 4.5 million rags because the Central Bank bought 500,000 rags worth. (b) The treasury sale has no effect on the money supply; the Treasury goes to the public to borrow money that it immediately spends. (c) When the Central Bank buys in the open market it pays with new high-powered money that becomes a part of the banking systems reserves; it pays essentially with newly printed money. The money multiplier is 1/RR or 1/0.2 or 5. Thus the money supply expands by 5 X 500,000 or 2.5 million rags. 5. Decrease the reserve ratio. This would immediately free up reserves (create excess reserves) system-wide. Banks could lend more, expanding the money supply. Decrease the discount rate. This would encourage banks to borrow reserves and lend more money, expanding the money supply. Buy government bonds. The Bank of Japan pays with cash or by increasing deposits in banks accounts. This increases reserves in the system and expands the money supply. 12. (a) The bank is required to hold .1($3,500) = $350 in reserves. (b) Excess reserves = $500 $350 = $150. (c) Assuming that money lent out by the bank gets deposited in this same bank, the bank can lend out an additional $150(1/.1) = $1,500. (d) New T-account: Assets Liabilities Reserves $300 Deposits $3,300 Loans $3,000 Required reserves are now $330. The bank has deficit reserves of $30. The bank will need to reduce its loans and increase its reserves by at least $30. This would result in reserves of $330, loans of $2,970, and deposits of $3,300.