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Free response question

Macroeconomics · Hard · 30 marks

IEO past paper: 2022 International Economics Olympiad, open questions

Question 3. "How to Finance Government Spending" Consider a closed economy where consumption spending depends on output: $C = C_0 + 0.8Y_d$ , where $C_0 > 0$ is autonomous consumption and $Y_d$ is disposable income (income after tax). The tax rate is flat at the level of 20% on all income without double taxation. The Short-Run Aggregate Supply (SRAS) is flat at $P = 1$ . Investment is given by $I = 7.5 - 4r$ , where $r$ is the real interest rate expressed in percentage points (for example, $r = 1.12$ means that the interest rate is 1.12%, not 112%). The supply of loanable funds is given by $S = 16r$ . Initially, the equilibrium level of GDP $Y^* = 100$ , all demand for loanable funds comes from investment, the state budget is balanced. The government wants to reduce unemployment and increases $G$ by 10.

(a)Assume that the government just has this money at its disposal, so there is no need to borrow it or find elsewhere. How will the increase in

G

affect GDP? If the increase in GDP does not equal the increase in

G

, explain the difference.[10](b)Now, assume that the government will finance its new spending through collected taxes, thus adjusting the tax rate. Find the new level of GDP in equilibrium. If it does not equal the new level of GDP in (a), explain the difference.[10](c)Assume that instead of raising taxes, the government will borrow 10 in the financial market, affecting the interest rate. How will this affect GDP when the goods market and the loanable funds market are in the new equilibrium? If it does not equal the new level of GDP in (a), explain the difference.[10]

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