1 Automatic Stabilizers
Suppose that consumption is modeled as in lecture:
C = c0 + c1YD
where YD = Y − T is disposable income. Now suppose that instead of treating taxes (T) as
exogenous, tax policy is conducted according to the following equation:
T = t0 + t1Y
that is, taxes depend on income. Assume that 0 < t1 < 1. Continue to treat government spending
(G) and investment (I) as exogenous.
- Solve for equilibrium output.
- What is the multiplier? Does the economy respond more to changes in autonomous spending
when t1 is 0 or when t1 is positive? Explain.
- Why would this type of fiscal policy be called an automatic stabilizer?
2 Balanced Budget vs. Automatic Stabilizers
Suppose tax policy is conducted as in the above problem.
- Solve for taxes in equilibrium.
- Suppose that the government starts with a balanced budget (ie. G = T) and that there is
then a drop in consumer confidence (c0 drops). What happens to income and taxes?
- Suppose that the government adjusts spending (G) to keep the budget balanced. What will
the effect be on Y ? Does this effect counteract or reinforce the effects of the drop in consumer
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