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- Suppose GDP is $1,500, consumption is $900, investment is $200, government purchases are $300, and taxes are $100. The marginal propensity to consume is 0.8. Is this economy in equilibrium? If so explain why, if not explain how it gets to an equilibrium.
- In problem 1, what is the equilibrium level of output?
- Explain why an increase in government purchases of 100 million dollars causes national income rise by more than 100 million dollars?

**Question 1**

Aggregate expenditure (Y) = C +G+I

But C= a+ b (Y-T)

A is autonomous consumption

b is the marginal propensity to consume.

I is investment

G is government purchases

T is taxes

Y=900+0.8(Y-100) +200+300

Y=900+0.8Y-80+500

Y=0.8Y+1320

Y-0.8Y=1320

0.2Y=1320

Y= $660

This economy is not in equilibrium since the potential GDP ($1,500) is not equal to the calculated DGP ($600).

The output gap is given by Y_{ p} -Y

1500-660=$840

The economy will get to the equilibrium by increasing the aggregate expenditure by $840, this will entail either increasing consumption, government expenditure or investments.

**Question 2**

The equilibrium level of output is $660

From the solution

Aggregate expenditure (Y) = C +G+I

But C= a+ b (Y-T)

A is autonomous consumption

b is the marginal propensity to consume.

I is investment

G is government purchases

T is taxes

Y=900+0.8(Y-100) +200+300

Y=900+0.8Y-80+500

Y=0.8Y+1320

Y-0.8Y=1320

0.2Y=1320

Y= $660

**Question 3**

Through the multiplier effect, government purchases leads to an increase in consumption and hence $100million government purchases will lead to more than $100 million raise in national income. Government purchases adds up consumption, which also leads to an addition in the national income.