Question

  

6. Suppose that the following information is given (Yd is disposable income):

C= 100 + (.75)(Y-T) G= 250

I= 150 t= 20% M= .15Yd

a) What would be the effect on output of a $50 increase in government spending? Show your work.

b) What if the marginal propensity to import was to increase. What would be the effect on output? Describe why it would affect economic activity.

c) What would be the effect on the equilibrium level of output if the tax rate were to increase? Explain and draw a graph of the goods market.

Answer 1

ANSWER:

GIVEN THAT:

THE FOLLOWING INFORMATION:

Y=C+I+G

Y= 100+(.75)(Y-T)+150+250= 100+(.75)(Y-.2Y)+400 = 100+0.6Y+400= 500+0.6Y

Y-0.6Y=500

Y=500/0.4= $1250

A.

1. After an increase in government spending by $50, the output will rise by $125. [Y=C+I+(G+50)] = 100+(.75)(Y-T)+150+250+50= 100+(.75)(Y-.2Y)+450 = 100+0.6Y+450= 550+0.6Y

Y-0.6Y=550

Y=550/0.4= $1375

B. THE MARGINAL PROPENSITY TO IMPORT WAS TO INCREASE:

1. Marginal propensity to import is the rise or decline in the imports with each unit increase or decrease in the disposable income.

2. With the rise in the marginal propensity to import, the amount out of the total expenditure on the imports increases which goes out of the circular flow of income, as this import demand is not passed in the form of the fresh spending in the economy.

3. This in result reduces the size of the multiplier. A smaller multiplier thus reduces the effect of government expenditure on the output of the economy.

C. THE EFFECT ON THE EQUILIBRIUM LEVEL OF OUTPUT:

1. With the increase in the tax rate, the disposable income with the consumers decline.

2. This reduction in disposable income when added to government expenditure and investment reduces the equilibrium output level of the economy.