Question 1: The behavioral functions are given as follows.C = 20 + 0.8(Y T); I =

Question

Question 1: The behavioral functions are given as follows.C = 20 + 0.8(Y T); I = 14; G = 20; T = 10; IM = 0.5Y; X = 0.1Y*; Y* = 100where Y is domestic income; Y* is foreign income; C is consumption; T is tax; I is investment;G is government spending; IM is import; X is export.

(A) Calculate the equilibrium level of output in closed economy.

(B) Calculate the equilibrium level of output in open economy case. Is this economy runningtrade deficit or surplus?

(C) Calculate the multiplier for closed economy case & for open economy case. Explain why the multipliers are different in two cases (I need an intuitive explanation).

Explanation / Answer

(A) In closed economy,

Y = C + I + G

Y = 20 + 0.8(Y - T) + 14 + 20

= 54 + 0.8(Y - 10)

Y = 54 + 0.8Y - 8

(1 - 0.8)Y = 46

0.2Y = 46

Y = 230

(B) In open economy,

Y = C + I + G + X - IM

= 20 + 0.8(Y - T) + 14 + 20 + (0.1 x Y*) - 0.5Y

= 54 + 0.8(Y - 10) + (0.1 x 100) - 0.5Y

Y = 54 + 0.8Y - 8 + 10 - 0.5Y

(1 + 0.5 - 0.8)Y = 56

0.7Y = 56

Y = 80

Trade balance = X - IM = (0.1 x 100) - (0.5 x 80) = 10 - 40 = - 30 < 0

A negative trade balance indicates trade deficit.

(C)

Multiplier in closed economy = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

Multiplier in open economy = 1 / (1 - MPC + MPM)** = 1 / (1 - 0.8 + 0.5) = 1 / 0.7 = 1.43

Open economy multiplier is smaller because of the import effect. Out of an increase in income caused by increase in spending, a portion is being spent on imports, resulting in leakage. That is why multiplier is smaller.

**MPM: Marginal propensity to import = 0.5

MPC: Marginal propensity to consume = 0.8

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