1. Suppose that the behavior of households and firms in an economy is determined

Question

1. Suppose that the behavior of households and firms in an economy is determined by the following equations C=200+0.75Yd, II = 30, G=50, T= 80, TR= 40. The full employment level of output in this economy is equal to YFE = 1200. a. Calculate an expression for aggregate demand as a function of income. [Pay attention to the fact that Yd = Y - T + TR] b. Calculate the equilibrium level of output. c. Is the government running a budget surplus or a budget deficit? What is its size? d. Calculate the government spending multiplier. e. Calculate the tax multiplier. f. How can the government bring the economy to full employment? Show two different methods. ..1 T-Mobile 4:51 AM HW15 DOCX -20 KB Close 1. Suppose that the behavior of households and firms in an economy iS determined by the following equations C-200+0.75Y,, I, = 30, G-50, T= 80, TR= 40. The full employment level of output in this economy is equal to Y" = 1200 a. Calculate an expression for aggregate demand as a function of income. [Pay attention to the fact that Yd = Y-T+TR] b. Calculate the equilibrium level of output. c. Is the government running a budget surplus or a budget deficit? What is its size? d. Calculate the government spending multiplier. e. Calculate the tax multiplier. f. How can the government bring the economy to full employment? Show two different methods. Email Word Save g. On the same graph, graph the 45-degree line and the original AD curve. Then show how AD changes after the government intervention to get the economy to full employment. Use a ruler below. You can also

Explanation / Answer

(a)

Aggregate demand: AD = C + I + G

AD = 200 + 0.75Yd + 30 + 50

AD = 280 + 0.75(Y - T + TR)

AD = 280 + 0.75(Y - 80 + 40)

AD = 280 + 0.75(Y - 40)

AD = 280 + 0.75Y - 30

AD = 250 + 0.75Y

(b)

In equilibrium, AD = Y

Y = 250 + 0.75Y

0.25Y = 250

Y = 1,000

(c)

Budget balance = T - G - TR = 80 - 50 - 40 = - 10

Since budget balance < 0, government is running a budget deficit equal to 10.

(d) MPC = 0.75

Government spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4

(e)

Tax multiplier = - MPC / (1 - MPC) = - 0.75 / 0.25 = - 3

(f)

Recessionary gap = YFE - Equilibrium Y = 1,200 - 1,000 = 200

To ensure full equilibrium, government has to increase output by 200 units. Two methods are possible.

(1) By increasing G

Required increase in G = Required increase in Y / Government spending multiplier = 200 / 4 = 50 units

(2) By decreasing T

Required decrease in T = Required increase in Y / Tax multiplier = 200 / 3 = 66.67 units

NOTE: First 6 parts are answered.

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