Question

2. Consider a Keynesian model of the economy with the following equations:

C = 300 + 0.7Yd

Transfer payments = 500

T = 0.1Y

I = 300

G = 400

X = 150

M = 0.2Y

(a) Calculate the equilibrium income level.

(b) Government spending on goods and services increases by 50. Calculate the new equilibrium level of income. (1 mark)

(c) If potential GDP is 2,750 what is the size of the output gap between potential and actual GDP (derived from (a) above)? How much should public spending have been increased by in order to have fully closed the output gap?

(d) In the short-run Keynesian model of income determination what is the cause of the output gap, and what are the possible macro solutions?

Answer 1

possible reason for negative output gap may be

1) recession.

2) low inflation

3) unemployment.

solution, fiscal expansion and monteary expansion so that aggregate demand will increase and hence GDP or output.