1. Early in 2008, economists predicted that in the absence of any change in fiscal and monetary policies, the declines in house and other asset prices would reduce private consumer spending by about $230 billion in that year. The Bush administration implemented a $150 billion tax rebate to counter the drop in private spending. Assume that for every dollar of increase in their disposable income (earnings net of taxes), American households spend $0.80 more on goods and services and save the rest. (Note: each dollar of tax rebate increases disposable income by $1.) Also, assume that for every dollar of spending, the US imports $0.20 worth of goods and services and the rest, $0.80, is spent on U.S. products.

(a) What was the direct impact of the 2008 tax rebate on total private spending?[3]

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(b) What was the direct impact of the 2008 tax rebate on total private spending on U.S. products?[3]

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(c) What was the direct impact of the 2008 tax rebate on the private spending of imported products (increase in imports)?[3]

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(d) The increased amount of spending on U.S. products that you calculated in part (b) had a second-round effect. It became income for the households in the country. If the average tax rate is 25 percent, what must have been the increase in household disposable income (i.e., after-tax income) in that 2^nd round? [3]

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(e) The increase in disposable income in the 2^nd round led to additional spending. The part of this additional spending that fell on domestic products in that round generated further income for domestic firms and entailed a 3^rd round of effects, causing increased disposable income, spending, imports, etc. Similarly, there were fourth, fifth, ... rounds of income and spending increase. The following table provides a method of organizing the information about these rounds, up to round 14 when the marginal increases became negligible compared to the initial stimulus.

Assume that in each round, the spending, import, and tax shares remained the same as described above. Calculate the increases in the variables listed in the last 4 columns of Table 1 for each listed round. Note: You may want to complete these calculations in spreadsheet software (such as Microsoft Excel) and transfer them back to this document. Please do not submit a separate document for your calculations. [10]

Rounds 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Total

Initial Tax Rebate 150 0 0 0 0 0 0 0 0 0 0 0 0 0 150

Increase in Disposable Private Income

Increase in Private Spending

Increase in Imports

Increase in Total Spending on Domestic Goods and Services

(f) Compare the total increase in spending on U.S. goods and services in rounds 1-14 with the tax rebate itself. Calculate the spending increase as a percent of the tax rebate. [3]

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(g) Keep in mind that in the absence of the tax rebate, 20% of the $230 billion spending decline would have been reduction in imports and 80% of it would have been reduction in the demand for domestic good and services. Was the tax rebate adequate to restore the demand for US goods and services? [6]

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