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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.
