\
) ,.
Macroeconomics 11-Popular Exam Q's MEMO
1. Using the Goods Market model explain how a balanced budget can still lead to an increase
in output and income. [OR] Using the Goods Market model explain how a simultaneous
increase in government spending and increase in taxes can lead to an increase in output
and income.
A balanced budget still increases output. The difference between the initial impact of a change in
government spending and a change in taxes implies that even if the change in G is equal to the
change in T, 8G = 8T, it will still have an expansionary effect on the economy.
By way of an example, assume that the increase in government spending is 100 (which is identical to
that ofthe amount received in taxes) i.e. b.G = b.T = 100. And that the marginal propensity to
consume (c or MPC) = 0.8. Applying the Goods Market model, the effect on income through
government spending is given by b.Y=ab.Gwhere a = _1_
1-c
and c being the marginal propensity to
consume (found as the slope on the ZZ curve).
Therefore a = _1_
1-0.8
=5 therefore b.Y=(5)(100) = 500 i.e. b.G=100 resulted in a b.Y=500 i.e. G is
autonomous and not influenced by c. Similarly the b.T=100 yields a decrease in b.Y=acb.T =
(5)(0.8)(100) = 400. Note the effect of c. The net effect is 500 minus 400 = 100 i.e. a growth in
output.
2. Using the Goods Market model z
explain how an increase in
government spending [OR] the use
, ,;
of fiscal policy can achieve full
lZ
employment.
The equilibrium level of output and 10
income, given the marginal propensity to ,;
,- "
consume and autonomous spending, is at ,- .;"
,,
,;
Yo, which is less than the level of full
employment (VF). At this point, the ,,
economy is experiencing unemployment
0
"
"4S
Y
i.e. the unemployment gap is YF - Vo and Yo YF
there are no forces present to ensure that
a movement to full employment will occur.
Using Keynes, this gap can be eliminated by increasing the demand for goods, ZZ, since it is the
demand for goods that determines the level of output and income. This can be achieved by
increasing autonomous spending e.g. l'C and/or the marginal propensity to consume, c.
1
, -',
,)
An increase in the MPC leads to a rise in
z
consumer spending, C, the demand for goods,
and the equilibrium level of output and income,
Y. An increase in autonomous spending, co,
causes an increase in the demand for goods,
which increases the level of output and income
and moves the economy closer to full
employment. Finally an increase in the MPC
implies that households spend a larger
proportion of every additional rand on
consumption. The term, c, in our consumption
equation is therefore larger and the slope ofthe
consumption curve steeper.
3. Explain and illustrate by using two different diagrams the impact of expansionary fiscal
policy in the Goods Market model and the IS-LM model. Also compare the results between
the two.
The Goods Market Model: Fiscal policy is the
government's policy on the level and composition z
of government spending, taxation and borrowing.
The main instrument of fiscal policy is the budget
and the main policy variables are government
spending and taxation.
An expansionary policy is used to stimulate
economic activity by increasing the demand for
goods (aggregate demand). An expansionary
fiscal policy means that government spending has
to be increased and/or taxes have to be
decreased such that using the Goods Market
model results in the following chain of events,
G1' ~Zi ~Yi ~Ci ~Zi ~Yi and, or
This leads to an output closer to full employment.
Note, too, that investment, interest rate and
inflation are unchanged as they are considered to
be exogenous.
The IS-LM Model: (Tip: Fiscal Policy has three
movements a -7 b -7 c and Monetary Policy has
two moves, a -7 b on my mindmaps.) The impact
of expansionary fiscal policy impacts the IS curve.
2
,)
Also given that the stimulus appears in the Goods market this will be the first for the chain of
events.) Expansionary Fiscal Policy according to the IS-LM model clearly shows that a decrease in
taxation causes a rise in the interest rate and an increase in output and income.
In the Goods Market: A decrease in the tax rate increases the disposable income. The increase in
disposable income causes an increase in consumption spending Le. C=co+ cY(+).This increase in
consumption causes an increase in the demand for goods, Z, since Z= C + I + G. (Tip: In the chain of
events; whenever C, I, G, Z or IM appears, the next change will be Z or ZZ. ZZ is generally used for
open economies.) The increase in demand increases the level of output and income. The chain of
events is -J;T => YD1' =>c1' =>Zl' =>Y1'.
The increase in output and income causes a further increase in consumption spending, demand for
goods and output via the multiplier effect Le. Y1' =>C1' =>Z1' =>Yl'. The increase in output and
income also increases investment spending because the level of sales increases by firms since
1=I(Y(+),i).The chain of event is Y1' =>11' =>Z1' =>Y1'. Once again via the multiplier effect.
Representing this in terms of the IS-LM model, the IS curve shifts to the right and the output
increases from Yoto Y2 above. (Note that interest rates have not changed since this is the Goods
market!)
Impact on the Financial Market: The increase in the level of output increases the demand for money,
Md, Le. Keynes' Liquidity Preference Theory (LPT) the demand for Active Balances (the Transaction
Motive), because there is a higher level of transactions. The increase in the demand for money leads
to an increase in the interest rate in the financial market Le. =>Y1' => Md 1'=>il'.
Back to the Goods Market: The increase in the interest rate decreases investment spending because
investment spending is a negative function ofthe interest rate Le. I=I(Y/)). (Tip: Changes in interest
rate will ALWAYS affect planned investments in the Goods Market.) This decrease in investment
spending decreases the demand for goods and the level of output and income decreases. In terms of
the IS-LM model, this is represented by a movement along the IS curve from point b to point al. The
chain of events: =>i1' =>I-J; =>Z-J; =>Y-J;. (Note now that point al represents a higher interest rate.)
The end result is a increase in the equilibrium level of output and income (Yoto Yl) and a higher
interest rate. This is the result of the increase in the demand for goods. Bear in mind that it is the
demand for goods that determines the level of output and income. Looking at the demand for
goods, Z1'= C1'+ 11'-J;+ G, consumption spending increases because a decrease in taxes and an
increase in output both increase disposable income. The impact on investment spending is
uncertain. Note that all other exogenous variables (government spending and money supply) except
taxation remain unchanged.
Often a spin on this question is posed. The question may read,
"What stabilisation policies could be employed by a country to get out of a recession using
the IS-LM mode'?"
3
, r
Now the answer above deals with the use 0/ Expansionary Fiscal Policy. The other stabilisation
"tool" is Expansionary Monetary Policy.
From this diagram it is clear that an increase in
nominal money supply causes a decrease in the LM
interest rate and an increase in output and
income. (Tip: NB!!! Since the stimulus
occurred in the Financial Markets, the chain of
events must start here.)
Impact on the Financial Market: The initial
impact is in the financial market where the
increase in the nominal money supply, M,
which increases the real money supply i.e. ~
(since that ~ = M(+)} causes the interest rate to
decline i.e. Ml' ~M/Pl' ~i,J,. and in terms of
our IS-LM model, the LM curve shifts to the right.
Impact on the Goods Market: The decrease in the interest rate increases investment spending, the
demand for goods and the level of output and income. The rise in the level of output and income
further increases investment as well as consumption spending i.e. ~i,J,. ~11' ~Zl' ~Vl' and now
for the multiplier process: Vl' ~11' and Vl' ~Cl'. In terms of the IS-LM model, this is represented
by a movement from point a to point al.
The end result is that the equilibrium level of output and income is higher and the interest rate is
lower. Both consumption spending and investment spending are higher. Note that government
spending and taxation remain unchanged i.e. Z1'= Cl'+ 11'+ G.
Additional Notes:
Decrease In autonomous spending Decrease In money supply
(contractlonary fiscal policy) (contractlonary monetary policy)
4
) ,.
Macroeconomics 11-Popular Exam Q's MEMO
1. Using the Goods Market model explain how a balanced budget can still lead to an increase
in output and income. [OR] Using the Goods Market model explain how a simultaneous
increase in government spending and increase in taxes can lead to an increase in output
and income.
A balanced budget still increases output. The difference between the initial impact of a change in
government spending and a change in taxes implies that even if the change in G is equal to the
change in T, 8G = 8T, it will still have an expansionary effect on the economy.
By way of an example, assume that the increase in government spending is 100 (which is identical to
that ofthe amount received in taxes) i.e. b.G = b.T = 100. And that the marginal propensity to
consume (c or MPC) = 0.8. Applying the Goods Market model, the effect on income through
government spending is given by b.Y=ab.Gwhere a = _1_
1-c
and c being the marginal propensity to
consume (found as the slope on the ZZ curve).
Therefore a = _1_
1-0.8
=5 therefore b.Y=(5)(100) = 500 i.e. b.G=100 resulted in a b.Y=500 i.e. G is
autonomous and not influenced by c. Similarly the b.T=100 yields a decrease in b.Y=acb.T =
(5)(0.8)(100) = 400. Note the effect of c. The net effect is 500 minus 400 = 100 i.e. a growth in
output.
2. Using the Goods Market model z
explain how an increase in
government spending [OR] the use
, ,;
of fiscal policy can achieve full
lZ
employment.
The equilibrium level of output and 10
income, given the marginal propensity to ,;
,- "
consume and autonomous spending, is at ,- .;"
,,
,;
Yo, which is less than the level of full
employment (VF). At this point, the ,,
economy is experiencing unemployment
0
"
"4S
Y
i.e. the unemployment gap is YF - Vo and Yo YF
there are no forces present to ensure that
a movement to full employment will occur.
Using Keynes, this gap can be eliminated by increasing the demand for goods, ZZ, since it is the
demand for goods that determines the level of output and income. This can be achieved by
increasing autonomous spending e.g. l'C and/or the marginal propensity to consume, c.
1
, -',
,)
An increase in the MPC leads to a rise in
z
consumer spending, C, the demand for goods,
and the equilibrium level of output and income,
Y. An increase in autonomous spending, co,
causes an increase in the demand for goods,
which increases the level of output and income
and moves the economy closer to full
employment. Finally an increase in the MPC
implies that households spend a larger
proportion of every additional rand on
consumption. The term, c, in our consumption
equation is therefore larger and the slope ofthe
consumption curve steeper.
3. Explain and illustrate by using two different diagrams the impact of expansionary fiscal
policy in the Goods Market model and the IS-LM model. Also compare the results between
the two.
The Goods Market Model: Fiscal policy is the
government's policy on the level and composition z
of government spending, taxation and borrowing.
The main instrument of fiscal policy is the budget
and the main policy variables are government
spending and taxation.
An expansionary policy is used to stimulate
economic activity by increasing the demand for
goods (aggregate demand). An expansionary
fiscal policy means that government spending has
to be increased and/or taxes have to be
decreased such that using the Goods Market
model results in the following chain of events,
G1' ~Zi ~Yi ~Ci ~Zi ~Yi and, or
This leads to an output closer to full employment.
Note, too, that investment, interest rate and
inflation are unchanged as they are considered to
be exogenous.
The IS-LM Model: (Tip: Fiscal Policy has three
movements a -7 b -7 c and Monetary Policy has
two moves, a -7 b on my mindmaps.) The impact
of expansionary fiscal policy impacts the IS curve.
2
,)
Also given that the stimulus appears in the Goods market this will be the first for the chain of
events.) Expansionary Fiscal Policy according to the IS-LM model clearly shows that a decrease in
taxation causes a rise in the interest rate and an increase in output and income.
In the Goods Market: A decrease in the tax rate increases the disposable income. The increase in
disposable income causes an increase in consumption spending Le. C=co+ cY(+).This increase in
consumption causes an increase in the demand for goods, Z, since Z= C + I + G. (Tip: In the chain of
events; whenever C, I, G, Z or IM appears, the next change will be Z or ZZ. ZZ is generally used for
open economies.) The increase in demand increases the level of output and income. The chain of
events is -J;T => YD1' =>c1' =>Zl' =>Y1'.
The increase in output and income causes a further increase in consumption spending, demand for
goods and output via the multiplier effect Le. Y1' =>C1' =>Z1' =>Yl'. The increase in output and
income also increases investment spending because the level of sales increases by firms since
1=I(Y(+),i).The chain of event is Y1' =>11' =>Z1' =>Y1'. Once again via the multiplier effect.
Representing this in terms of the IS-LM model, the IS curve shifts to the right and the output
increases from Yoto Y2 above. (Note that interest rates have not changed since this is the Goods
market!)
Impact on the Financial Market: The increase in the level of output increases the demand for money,
Md, Le. Keynes' Liquidity Preference Theory (LPT) the demand for Active Balances (the Transaction
Motive), because there is a higher level of transactions. The increase in the demand for money leads
to an increase in the interest rate in the financial market Le. =>Y1' => Md 1'=>il'.
Back to the Goods Market: The increase in the interest rate decreases investment spending because
investment spending is a negative function ofthe interest rate Le. I=I(Y/)). (Tip: Changes in interest
rate will ALWAYS affect planned investments in the Goods Market.) This decrease in investment
spending decreases the demand for goods and the level of output and income decreases. In terms of
the IS-LM model, this is represented by a movement along the IS curve from point b to point al. The
chain of events: =>i1' =>I-J; =>Z-J; =>Y-J;. (Note now that point al represents a higher interest rate.)
The end result is a increase in the equilibrium level of output and income (Yoto Yl) and a higher
interest rate. This is the result of the increase in the demand for goods. Bear in mind that it is the
demand for goods that determines the level of output and income. Looking at the demand for
goods, Z1'= C1'+ 11'-J;+ G, consumption spending increases because a decrease in taxes and an
increase in output both increase disposable income. The impact on investment spending is
uncertain. Note that all other exogenous variables (government spending and money supply) except
taxation remain unchanged.
Often a spin on this question is posed. The question may read,
"What stabilisation policies could be employed by a country to get out of a recession using
the IS-LM mode'?"
3
, r
Now the answer above deals with the use 0/ Expansionary Fiscal Policy. The other stabilisation
"tool" is Expansionary Monetary Policy.
From this diagram it is clear that an increase in
nominal money supply causes a decrease in the LM
interest rate and an increase in output and
income. (Tip: NB!!! Since the stimulus
occurred in the Financial Markets, the chain of
events must start here.)
Impact on the Financial Market: The initial
impact is in the financial market where the
increase in the nominal money supply, M,
which increases the real money supply i.e. ~
(since that ~ = M(+)} causes the interest rate to
decline i.e. Ml' ~M/Pl' ~i,J,. and in terms of
our IS-LM model, the LM curve shifts to the right.
Impact on the Goods Market: The decrease in the interest rate increases investment spending, the
demand for goods and the level of output and income. The rise in the level of output and income
further increases investment as well as consumption spending i.e. ~i,J,. ~11' ~Zl' ~Vl' and now
for the multiplier process: Vl' ~11' and Vl' ~Cl'. In terms of the IS-LM model, this is represented
by a movement from point a to point al.
The end result is that the equilibrium level of output and income is higher and the interest rate is
lower. Both consumption spending and investment spending are higher. Note that government
spending and taxation remain unchanged i.e. Z1'= Cl'+ 11'+ G.
Additional Notes:
Decrease In autonomous spending Decrease In money supply
(contractlonary fiscal policy) (contractlonary monetary policy)
4
