1. This question refers to the Simulation Model for U.S. Potential GDP in excel on the course website.
You are part of a taskforce charged by the Secretary of the Treasury with recommending how togradually reduce the federal budget deficit (≡ G-T), to zero over ten years.Your job is to examine the impact of two different policies on potential or trend GDP growth.
The head of the taskforce, asks you to evaluate two extreme solutions:
(1) Eliminate the government budget deficitsolely by gradually cutting government spending enough to wipe out the deficit by 2026.
(2) Eliminate the deficit solely by graduallyincreasing taxes enough to wipe out the deficit 2026.
Option (1) requires cutting the growth in G while option (2) requires increasing the growth in tax revenues. Your tool for analysis is the Potential GDP Model found in the posted excel spreadsheet in the Assignments folder. This model is calibrated to the U.S. economy circa 2015-16. This model isto be used to undertake simulations to evaluate the two policy options above. (Note: In your simulations you don't have to exactly hit a balanced budget (G- T=0) in 2026, plus or minus $75B is OK.)
(Do not turn in a spreadsheet or a printout of a spreadsheet! Write up your conclusions in a 1 to 2 page executive summary format. In your summary usethe economics behind the simulation model to explain why you found what you did.)
2. Suppose that the President and Congress decide to increase spending on water pipelines to the western United States to ease drought conditions there. The additional G spending for this project is ?G=50. To get an agreement, taxes will go up by exactly the amount that G goes up, ?T=50, so the budget remains in balance.
Use the model below to work out your answers. Use an r-S graph to show the action.
The model economy:
Y = 10,000
C = .75(Y-T)
I= 2300-10r
NX=0
Assume that prior to the increase in G and T that G=1,200 and T=1,200.
a. Calculate the values of C, S, I and r before G and T go up?
b. What happens after the increased spending to C, S, I and r? What explains the changes in S, I and r? Use Words.
c. Work out a tax policy (assuming G goes to 1,250) that keeps S and I at their original levels. Explain why this policy works?
3. Suppose that Investment was divided into Residential Investment (houses, apartments, etc) and Business Investment (plant, equip, computers, etc). The government has decided to stimulate investment in housing as a "pro-family" policy. It does this by giving a tax break to those that buy housing. Assume that the house-buying tax break is "revenue neutral" for the government so the total amount of taxes, T, which households pay in the aggregate is unchanged.
What will happen to (a) residential investment, (b) business investment, (c) total investment and (d) the real interest rate as a result of introducing this tax break?
To be concrete use the following model to work out what happens.
(Hint: Remember that total investment in the economy is restricted to equal the supply of national savings.)
Y = AK.3L.7
A=10, K=121, and L=121
Y = C+I+G+NX.
C= 150+.5(Y-T), NX=0, and that G = 100 and T = 100.
Demand for residential investment: IRES = 212.5 - 5r
Demand for business investment: IBUS = 212.5 - 5r
Total investment: I = IRES + IBUS = 425 - 10r.
The tax break causes demand for residential investment to increase by 25 billion at every interest rate so the new residential demand curve is IRES = 212.5 - 5r +25 = 237.5 - 5r.
There is no change in the demand curve for business investment.
Attachment:- Potential GDP Simulation Model.rar