The current position of the economy is given by the following variables: Ca = 30

Question

The current position of the economy is given by the following variables:

Ca = 300(autonomous consumption)<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

G = 500

T = 500

I = 200

X= 100

M = 200

MPC = 0.60

Y (income) = Aggregate expenditures (C+I+G+X-M)

At equilibrium, AE=Y,

i.e. Y = C+I+G+X-M = [Ca+0.6*(Y-T)]+I+G+X-M =

i.e. Y*= 1500

Now suppose that the full employment GDP = 2000

The spending multiplier is, m= 1/(1-mpc) = 1/(1-0.6) = 2.5

(-MPC) / (1-MPC)= -0.6/0.4= -1.5

Explanation / Answer

Ca = 300(autonomous consumption)

G = 500

T = 500

I = 200

X= 100

M = 200

MPC = 0.60

Y (income) = Aggregate expenditures (C+I+G+X-M)

Find the equilibrium level of GDP (Y*). (3 points)

At equilibrium, AE=Y,

i.e. Y = C+I+G+X-M = [Ca+0.6*(Y-T)]+I+G+X-M =

i.e. Y*= 1500

Now suppose that the full employment GDP = 2000

The spending multiplier is equal to what? (1 point)

The spending multiplier is, m= 1/(1-mpc) = 1/(1-0.6) = 2.5

What is the necessary change in government spending alone that is needed to get the economy to full employment? (2 points)

To get to full employment, equilibrium output has to increase by 500.

We have dY/dG=2.5,

i.e. dG =dY/m = 500/2.5 = 5000/25 = 200. Hence government expenditure has to increase by 200 for the economy to reach full employment.

The tax multiplier is equal to what? (1 point)

The tax multiplier is given by, dY = dCa + cdY-cdT + dI+dG+d(X-M); dG=dI=dCa=d(X-M)=0,

i.e. (1-c) dY = -cdT,

i.e. dY/dT =-c/(1-c) = (-MPC) / (1-MPC)= -0.6/0.4= -1.5

What is the necessary change in taxes alone that is needed to get the economy to full employment? (3 points)

To get to full employment, equilibrium output has to increase by 500.

We have dY/dT=-1.5,

i.e. dT =dY/-1.5 = -500/1.5 = -333.33. Hence taxes alone have to decrease by 333.33 for the economy to reach full employment.

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