Assume that the Government has announced

Subject: Economics    / General Economics
Problems Set 2

1. Assume that the Government has announced a cut in Government Spending
followed by a tax increase:
a) Can you establish the macroeconomics effects of these policies on
consumption, investment, interest rate and savings? Use the models
(consumption model and loanable funds market) and the graphs.
b) What about the aggregate demand (AD)? Use the Keynesian cross.

2. If the government wants to increase the amount of savings in the economy, how
should it alter government spending? What effect will this action have on the
interest rate in the economy? (Use the appropriate graph to illustrate the effect and

3. Let the following equations characterize an economy: (note the addition of a tax
rate on output) Y = 500
C = 60 + 0.8(Y-T)
I = 30 – r
G = 100
T = 0.4Y
a. Calculate national saving, private saving, and public saving.
b. Obtain the mathematical expression for the AD in this particular economy.
c. Determine the equilibrium interest rate (you can use the loanable funds market).
Draw the graph.
d. If Government spending increases to 120, what is the effect on income? Use the
multiplier and calculate the increase in Y. Draw the new equilibrium in a graph (old
and new in same graph).

4. Let´s suppose the Congress passes a bill which decreases marginal and average
income tax rates. Analize how this policy affects consumption, savings and
investment, interest rate and income in short-run equilibrium. Use all graphs and
equations. Give a brief explanation.

5. Explain how an investment tax break could affect investment, aggregate demand
and income. Use all graphs and explain.