Principles of Economics - Course 2020-2021 - Problem Set 11

Conceptual Questions
Write down a short and concise answer. When you are asked to solve the question in class, explain
the concept clearly and give examples or pieces of evidence.
1. In France and Germany, it is difficult for a household to increase its borrowing based on an
increase in the market value of the house. In addition, large down-payments (as a percentage of
the house price) are required for house purchases. On the basis of this information, how would
you expect a rise in house prices in France or Germany to affect spending by households?
For house owners in France and Germany, an increase in house prices will have little effect on
their spending, given that borrowing is not affected by the value of their properties. However,
the increase in house prices increases the down payment required and households hoping to
purchase a house will have to save more in order to be able to pay a deposit. This will depress
autonomous consumption for those households. Refer to the VoxEU article for more details.
2. In the US or UK, loans are more easily available based on a rise in home equity and only a
small down-payment is required. How would you expect your answer to question 1 to change
when considering the US or UK? What do you conclude about the role of the financial
accelerator in France and Germany compared with the UK and the US?
In the UK or US, house owners may increase their spending given that they experience a
wealth effect and also can now borrow more. The role of the financial accelerator is largely
absent in France and Germany whereas it has an effect on consumption in the UK and US. This
is because consumers may invest in properties and later use these assets to borrow. If there is a
rapid decrease in house prices, the consumers' ability to borrow (and finance further
investment) will be restricted. Combined with depressed demand for their products, they will
be heavily affected by the depression.
3. Consider the three methods discussed in this unit that have been used to estimate the size of the
multiplier: the Mafia-related dismissals in Italy, the stimulus highway spending in the US, and
wartime defence spending in the US. Why do you think estimates of the size of the multiplier
vary? Use the material in this unit to support your explanation.
The principal reason is that the size of the multiplier will vary depending on the situation of the
economy (as discussed in Exercise 14.3), and these three ‘tests’ were carried out in very
different circumstances. For example, in a recession, a fiscal stimulus (such as highways
spending) is likely to be more efficient than during a boom. This is because there is more spare
capacity, which could be used. Indeed, the stimulus may even encourage private investment if
confidence is very low. A similar stimulus when there is no spare capacity (as during a war, for
example) is likely to have a much smaller multiplier effect. The increase in aggregate demand
may simply cause prices to rise, with no effect on output.
Furthermore, the form of the stimulus differed in each of the cases: investing in highways is not
the same as investing in wartime defence. Some stimuli may be more efficient than others e.g.
might employ more people or disproportionately benefit those who may not need it as much
(such as the relatively affluent). Multipliers will thus differ.
4. In an article from August 2014, ‘The Fall of France’(http://tinyco.re/7111032), Paul Krugman
criticizes the austerity policy implemented in France. Use what you have learned about the
fiscal multiplier to explain why, in Krugman’s opinion, fiscal austerity in France (and more
generally in Europe) would fail (explain carefully what you think Krugman means by ‘fail’).
In Krugman’s article, ‘fiscal austerity’ means cuts in government spending and increases in
taxation intended to balance the budget. The immediate effect is a reduction in aggregate
demand as shown in Figure 14.11. This, in turn, will lead to decreased output with reductions
in consumption and investment. This further reduces demand and output through the multiplier
process. As we have seen in Exercise 14.4, the overall effect on government finances will
depend on whether the cuts in government expenditure outweighs the reduction in tax receipts
due to lower spending and whether generous automatic stabilisers increase government
spending. Krugman is also worried about imported recession i.e. many countries in Europe

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export products to France. If consumption expenditure in France decreases, it will adversely
impact the economies of the exporting countries as well. In the context of the article, "fail"
means not to provide stimulus to aggregate demand in the French economy. This will make it
difficult for France to escape recession and will also have adverse effects on the rest of the
Eurozone.

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 Problems

1. Assume the economy is in a recession. The government has a high level of debt and
wants to set a balanced budget, that is, G = T. How can the government achieve a
fiscal stimulus effect on GDP whilst keeping the budget balanced?
To answer the question, take the following steps:
a. Show how this is possible in a multiplier diagram, ensuring that you label
the relevant intercepts and angles. Make the diagram sufficiently accurate
so that the exact size of the multiplier is visible.
b. Explain in words how the government can achieve such a fiscal stimulus
effect whilst keeping the budget balanced.
c. Derive the balanced budget multiplier using algebra. (Hint: You will need to
write down expressions for the change in GDP associated with a change in
both G and T and set these equal to each other.)
d. Comment briefly on any disadvantages you see with the use of this balanced
budget fiscal stimulus.
You can make the following assumptions:
a. Assume a lump sum tax. This means that the tax does not depend on the
level of income, T = T, rather than our usual assumption that T = tY.
b. Also assume that the country does not have any imports or exports.

a. See diagram below

b. We assume that the MPC (C1) is 0.75 giving a multiplier value of 4. An

increase of government spending of 2bn increases output by 8bn from Y to Y’.
A tax increase of 2bn means an initial reduction of spending of 1.5bn. The
negative multiplier effect (4 x 1.5) reduces output from Y’ to Y”. The net
multiplier effect of 1 is shown by Y”-Y’.
The key to the balanced budget multiplier lies in the fact that the multiplier
applies to the initial change in spending and that consumption takes place out of
disposable (i.e. post-tax) income. Hence, a tax rise (or cut) triggers the
multiplier because it causes a change in spending in the form of consumption.

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 But since consumption takes place out of disposable income, only a fraction of
the tax change is converted into an initial change in spending. In the example
above, we see that the balanced budget effect is the net outcome of two
changes. The first is the increase in government spending of 2bn, the whole of
which is subject to the multiplier (we have assumed this is equal to 4, MPC =
0.75); the second is the decrease in consumer spending caused by the tax
increase. Note that this increase is the same as the increase in government
spending (so the budget remains unchanged) but only a fraction of it
(determined by the MPC) is translated into a reduction in spending. In our
example, government spending increases by 2bn but this is only partially offset
by a reduction in consumer spending of 1.5bn (= 0.75 x 2bn). Hence there is a
net increase in output of 2bn – the size of the original fiscal stimulus.
c.

d. The multiplier may be less than one, because people can cut consumption based
on psychological effects of the tax increase. It could also be greater than one if
higher-income people cut their consumption by relatively less than lower-
income people. In certain circumstances it might be impossible for the
government to borrow (for example, if the debt-to-GDP ratio is high and
lenders fear a sovereign debt crisis).
Lastly, there are political issues related to changes in taxation: the political
climate may not permit government to increase taxation, because most of the
benefits of this plan would go to the minority of the unemployed, while the
extra taxes would however be paid by the majority in employment. There might
also be political objections that the actual expenditures benefit one
group rather than another.
2. Consider the multiplier model
a. Compare two economies, which differ only in their share of credit
constrained households but are identical otherwise. In which economy is the
multiplier larger? Illustrate your answer using a diagram.
b. On the basis of your comparison of the two economies, would you expect
the multiplier in an economy to vary over its business cycle?
c. Some economists estimated the size of the multiplier in the Great
Depression to be equal to 1.8. Explain how the following characteristics of
the US economy at the time could have affected its value:
i. the size of government (see Figure 14.1)
ii. the fact that there were no unemployment benefits
iii. the fact that the share of imports was small

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a. The consumption line will be steeper (and the multiplier larger) in the economy
with the greater proportion of credit-constrained households (whose consumption
largely varies with income, compared to households with credit access).
In the graph below, in the upper quadrant, we begin at A. We then assume that
there is an increase in investment spending of 2bn and the aggregate demand
schedule shifts upward from AD to AD’. This takes us initially from A to B.
Demand now exceeds output and so output increases. This increase in output is also
an increase in real income and so consumption begins to rise and so instead of
staying at output expands to C (on the 45o line). Here again aggregate demand
exceeds output at D and so output (and income) increase again. This followed by a
further increase in consumption (as a result of the MPC), and we eventually
converge to a new equilibrium at Z where income, output, and aggregate demand
are all equal. Notice that the expansion in output that has occurred (the horizontal
distance between A and Z) is 3bn.
Compared with the original increase in investment (2bn) this yields a multiplier
value of (3/2) or 1.5. We repeat the process in the lower quadrant but notice that the
AD curve is steeper (the MPC is higher). This means that the initial increase in
spending induces a larger increase in consumption as output rises and this has a
larger reinforcing effect on the disturbance to aggregate demand. We have omitted
some of the arrows for the sake of clarity, but we can clearly see that the horizontal
distance between the initial and final equilibrium is larger than before (4bn rather
than 3bn). Since the initial disturbance is still 2bn, the multiplier has the larger
value of 4/2 = 2.

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b. In a recession, banks are more reluctant to provide loans. Households
are thus more credit constrained and the multiplier is larger. On the other
hand, in a boom banks tend to be more relaxed with lending, credit
constraints are less severe, the multiplier is thus smaller.
c. Recall the multiplier (see the Einstein from Section 14.5):
k=
( 1
1−c1 (1−t)+m )
At the beginning of the Great Depression, government spending and
taxation was much smaller as a fraction of GDP than it is now. This
would give rise to a larger multiplier.
Recall that marginal propensity to consume (MPC = C1) decreases with
income; the relatively rich consume a smaller fraction of their income
than the relatively poor, because they are willing to save a larger share
of their income. Let’s assume that unemployment benefits are a source
of income. Hence, in an economy where a large share of unemployed
workforce has no savings and few assets, C1 will be relatively larger
without unemployment benefits (ceteris paribus). On the other hand,
ceteris paribus, C1 will be relatively smaller with the benefits.
Therefore, in this type of economy, no unemployment benefits imply
relatively larger C1, thus a relatively larger multiplier.
A small share of imports implies that most consumption expenditure is
used on domestic goods. This increases the multiplier, because demand
for domestic products and services decreased by relatively less than in a
more open economy (where consumers could substitute to imported
goods). In the formula, lower levels of m increase the multiplier effect.
It is useful to think of the tax rate, t, and the propensity to import, m, as
‘leakages’ from the circular flow of income. Remember: the larger
theleakages, the smaller the multiplier and vice versa.

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 Other Questions
1. The diagram depicts a consumption function of an economy, where C is the aggregate
consumption spending, Y is the current income of the economy, and c0 is the fixed (or
autonomous) consumption such that c0 > 0. Assume that households that are not credit-
constrained would completely smooth their consumption. Which of the following
statements is correct?
a. If all households were not credit-constrained, and all income changes were
perceived to be temporary, then the aggregate consumption line would be
horizontal.
b. During a credit crunch when the banks become less willing to lend, the
aggregate consumption line would become flatter.
c. If a higher proportion of households have "weakness of will", then the
aggregate consumption line would be flatter.
d. If the current income falls to zero, there will be zero consumption.

.
a. In this case, all households can completely smooth consumption and would not
react to temporary changes in income, so the aggregate consumption line would
be horizontal.
b. In a credit crunch, more households would become credit-constrained so their
marginal propensity to consume would increase. Therefore the line would
become steeper.
c. “Weakness of will” means that when there is an expected fall in the income, the
households are less likely to adjust their consumption ahead of the fall, in order
to build up some savings so that they can smooth consumption. In this case
their marginal propensity to consume would be higher, implying a steeper
aggregate consumption line.
d. c0 > 0 means that even if the current income is zero, the households will
consume a strictly positive amount.
.
2. Assuming that there is no government spending or trade, an economy’s aggregate
demand is given by its domestic consumption C and investment I, AD = C + I = c0 +
c1Y + I. In the economy’s goods market equilibrium this equals its output: AD = Y.
Solving for Y this yields:
Y = [1/(1 -c1 )] (c0+ I)
Given this equation, which of the following statements is correct?

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 a. The multiplier is given by 1 – c1.
b. The boost in the economy’s output is the same, regardless of whether the
aggregate demand shock comes from an increase in investment I or in
autonomous consumption c0.
c. The larger the marginal propensity to consume (c1), the smaller the multiplier.
d. If c1 = 1/3, then a £1 million increase in investment would result in a £2 million
increase in output, ceteris paribus.
a. The multiplier is given by 1 / (1 – c1).
b. The same multiplier (1 / (1 – c1)) applies to both autonomous consumption and
investment.
c. A larger c1 means a smaller 1 – c1, which in turn means a larger multiplier 1 / (1
– c1).
d. When c1 = 1/3, then 1 / (1 – c1) = 1.5, and therefore a £1 million increase in I
would result in a £1.5 million increase in Y.
3. In the US and the UK, loans are widely available based on a rise in home equity.
Additionally, unlike in France and Germany where large down-payments (as a
percentage of the house price) are required, in the US and the UK only small down-
payments are required for house purchases. On the basis of this information, which of
the following statements is correct for the US and the UK when there is a rise in
housing prices.
a. There is a positive financial accelerator effect for the existing homeowners who
are credit-constrained.
b. There would be no effect on the consumption of existing homeowners who are
not credit-constrained.
c. Aspiring homeowners are likely to increase saving and reduce their
consumption more than they would in France and Germany.
d. A rise in housing prices is likely to dampen consumption in the US and the
UK .
a. For credit-constrained homeowners, an increase in their house price can
increase consumption spending because the higher collateral would enable
higher borrowing.
b. For those for are not credit-constrained, a rise in housing prices would improve
their net worth and raise their wealth relative to target levels. This leads to
reduced precautionary savings, increasing their consumption.
c. As only small down-payments are required, the negative effect on the
consumption would be smaller in the US and the UK than in France and
Germany.
d. As opposed to France and Germany, the positive financial accelerator effect and
the positive collateral effect are likely to outweigh the effect of the increased
saving by the aspiring homeowners, resulting in higher consumption.

4. Which of the following statements regarding the multiplier is correct?

a. If two countries were identical except for the share of credit-constrained
households, then the country with the higher share would have a smaller
multiplier.
b. The multiplier is constant over the business cycle.
c. An increase in the level of exports leads to a higher multiplier.

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d. Taxation and imports are “leakages” from the circular flow of income, which
reduce the size of the multiplier.
a. A higher share of credit-constrained households means a higher marginal
propensity to consume. Therefore the multiplier will be larger.
b. The proportion of credit-constrained households would vary over a business
cycle. The multiplier would therefore vary accordingly.
c. The multiplier in an open economy depends on the marginal propensity to
consume, the marginal propensity to import, and the income tax rate. The level
of exports does not affect the multiplier (it affects the level of the aggregate
demand curve, but not the slope).
d. Some household income goes back to the government via taxes, and some is
spent on goods and services produced abroad. These both reduce the effect of
government spending on the domestic economy.