Question

Consider two economies. In economy A: autonomous consumption equals 700, the marginal propensity to consume equals 0.80, taxes are fixed at 50, investment is 100, government spending is 100, and net exports are 40.

In economy B: autonomous consumption equals 1000, the marginal propensity to consume equals 0.8, taxes are proportional to income such that consumers pay 25% of their income as taxes, investment is 250, government purchases are 150, and net exports are 400.

(i) What is the planned aggregate expenditure (PAE) in each economy?

(ii) What is the short-run equilibrium output in each economy?

(iii) In which economy is the spending multiplier higher?

(iv) Suppose autonomous consumption fall by 500 in each economy. Which economy will see a higher drop in GDP? Compute the equilibrium output in each economy.

Answer 1

Answer:

Given that:

Consider two economics .In economy A : autonomous consumption equals 700,the marginal propensity to consume eqials 0.80.

i)

For economy A : PAE = C + I + G + NX

C = Autonomous consumption + MPC (Y-T)

C = 700 + 0.80 (Y- 50)

C = 660 + 0.80Y

PAE = 660 + 0.80Y + 100+ 100+ 40

PAE = 900 + 0.80Y

For ecoonomy B : PAE = C+I+G+NX

C = Autonomous consumption + MPC ( Y-tY)

C = 1000 + 0.80 (Y - 0.25Y)

= 1000 + 0.80(0.75Y)

= 1000 +0.6Y

PAE = 1000+ 0.6Y + 250 + 150+ 400

PAE = 1800 +0.6Y

ii)

Short run equilibrium occurs when PAE = Y

For economy A : Y = 900+0.80 Y

0.20Y = 900

Y = 4500 (Equilibrium output of economy A)

For economy B : Y = 1800+ 0.6Y

0.4 Y = 1800

Y = 4500 (Equilibrium output of economy B)

iii)

Spending multiplier in economy A = 1/1-MPC

= 1/1-0.80

= 1/0.2

= 5

Spending multiplier in economy B = 1/1-0.60

= 2.5

Multiplier is higher in economy A.

iv)

Suppose autonomous consumption fall by 500 in each economy. Then , for economy A : GDP will decrease by (5)(500)= 2500 ,

so the equilibrium in economy A = 4500-2500

= 2000.

And for economy B , GDP will decrease by (2.5)(500)= 1250 ,

so the equilibrium in economy B = 4500-1250

= 3250.

The higher drop in GDP is in economy A.

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