Tutorial 7 Principles of Economics
1. Let us introduce taxes in the Keynesian cross. Consumption expenditure can be written as:
C = C0 + cˆ(Y − T ) . Suppose the government reduces taxes by €2 billion, that there is no
crowding out and that the marginal propensity to consume is 0.75.
a. What is the initial effect of the tax reduction on aggregate demand?
b. What additional effects follow this initial effect? What is the total effect of the tax cut on
aggregate demand?
c. How does the total effect of this €2 billion tax cut compare to the total effect of a €2 billion
increase in government purchases? Why?
2. Use IS-LM analysis to explain the following:
a. The government institutes significant cuts in public expenditure.
b. The central bank institutes an asset purchasing facility which expands the money supply by
€300 billion.
c. The central bank fears that inflationary pressures are rising and increases interest rates.
d. The government increases taxation to try and reduce a large budget deficit.
3. Explain the effect of deflation on the economy using the IS-LM model and then what effect
it would have on aggregate demand and why.
4. Suppose economists observe that an increase in government spending of €10 billion raises
the total demand for goods and services by €30 billion.
a. If these economists ignore the possibility of crowding out, what would they estimate the
marginal propensity to consume (MPC) to be?
b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC
be larger or smaller than their initial one? Explain your answer.
5. Suppose that the economy is in a long-run equilibrium.
a. Use a diagram to illustrate the state of the economy. Be sure to show AD, short-run AS and long-run
AS.
b. Now suppose that a financial crisis causes AD to fall. Use your diagram to show what happens to
output and the price level in the short run. What happens to the unemployment rate?
c. Use the sticky wage theory of AS to explain what will happen to output and the price level in the
long run (assuming there is no change in policy). What role does the expected price level play in this
adjustment? Be sure to illustrate your analysis with a graph.
6. Explain whether each of the following events will increase, decrease or have no effect on long-run
AS. Additionally also describe what happens to the SRAS or AD.
a. The country experiences a wave of immigration.
b. The government raises the minimum wage above the national average wage level.
c. A war leads to the destruction of a large number of factories.
7. Explain whether each of the following events shifts the short-run AS curve, the AD curve, both, or
neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy.
a. Households decide to save a larger share of their income.
b. Cattle farmers suffer a prolonged period of foot-and mouth disease which cuts average cattle herd
sizes by 80 per cent.
c. Increased job opportunities overseas cause many people to leave the country.
8. Suppose that firms become very optimistic about future business conditions and invest heavily in
new capital equipment.
a. Use an AD/AS diagram to show the short-run effect of this optimism on the economy. Label the new
levels of prices and real output. Explain, in words, why the aggregate quantity of output supplied
changes.
b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now,
assume there is no change in the long-run AS curve.) Explain, in words, why the aggregate quantity of
output demanded changes between the short run and the long run.
c. How might the investment boom affect the long-run AS curve? Explain.
9. The economy is in a recession with high unemployment and low output.
a. Use a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure
to include the aggregate demand curve, the short-run aggregate supply curve, and the long-run
aggregate supply curve.
b. Identify an open-market operation that would restore the economy to its natural rate.
c. Use a graph of the money market to illustrate the effect of this open-market operation. Show the
resulting change in the interest rate.
d. Use a graph similar to the one in part (a) to show the effect of the open-market operation on output
and the price level. Explain in words why the policy has the effect that you have shown in the graph.
10. Illustrate the effects of the following developments on both the short-run and long-run Phillips
curves. Give the economic reasoning underlying your answers:
a. a rise in the natural rate of unemployment
b. a decline in the price of imported oil
c. a rise in government spending
d. a decline in expected inflation.