Question

Practice with the Expenditure-Output Model

Complete the following. Write your answers in the green spaces. When you are finished, save your work and upload it to the appropriate folder in the Assignments section of D2L.

Note: all of the following calculations are in $billions (e.g. $100 = $100 billion). Economists sometimes express their formulas in $billions to avoid writing out a large number of ‘0’s.

In country X, potential GDP is $3,200.

BENCHMARK CASE. Spending is guided by the following equations:

C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $0

IM = $0

Compute the current level of GDP: ________________

Is there an inflationary gap, recessionary gap, or no gap? ______________________

PESSIMISM. Investors in the economy become pessimistic about the future. Spending is now guided by the following equations:

C = $600 + 0.75(Y – T)

I = $100

G = $0

T = $0

EX = $0

IM = $0

Compute the current level of GDP: ________________

Is there an inflationary gap, recessionary gap, or no gap? ______________________

GOVERNMENT SPENDING. Country X decides to increase government spending on infrastructure but keep taxes fixed, causing a budget deficit. Spending is now guided by the following equations:

C = $600 + 0.75(Y – T)

I = $200

G = $100

T = $0

EX = $0

IM = $0

Compute the current level of GDP: ________________

Is there an inflationary gap, recessionary gap, or no gap? ______________________

TRADE. Country X opens its borders to international trade. Given interest in foreign and domestic products, a trade deficit appears. Spending is now guided by the following equations:

C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $100

IM = $200

Compute the current level of GDP: ________________

Is there an inflationary gap, recessionary gap, or no gap? ______________________

BONUS. Imports in Country X become tied to GDP. Imports amount to 5% of GDP. Spending is now guided by the following equations:

C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $100

IM = 0.05Y

Compute the current level of GDP: ________________

Is there an inflationary gap, recessionary gap, or no gap? ______________________

Answer 1

The current level of GDP is determined by the equation Y=C+I+G+EX-IM. Potential GDP=3200. If current level of GDP is greater than potential GDP then there is inflationary gap, if less than potential GDP then there is recessionary gap and if equal then no gap.

a) C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $0

IM = $0

So Y=600+0.75(Y-0)+200. Solving for Y we get Y=3200

current level of GDP: = $3200

Is there an inflationary gap, recessionary gap, or no gap? No gap

b) C = $600 + 0.75(Y – T)

I = $100

G = $0

T = $0

EX = $0

IM = $0

So Y=$600 + 0.75(Y – 0)+100. Solving for Y we have Y=2800

current level of GDP: $2800

Is there an inflationary gap, recessionary gap, or no gap : Recessionary gap

c) C = $600 + 0.75(Y – T)

I = $200

G = $100

T = $0

EX = $0

IM = $0

Y=$600 + 0.75(Y – 0)+200+100. SOlving for Y we get Y=3600

current level of GDP: $3600

Is there an inflationary gap, recessionary gap, or no gap : Inflationary gap

d) C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $100

IM = $200

Y=$600 + 0.75(Y – 0)+200+100-200. Solving for Y we get Y=2800

current level of GDP: $2800

Is there an inflationary gap, recessionary gap, or no gap : Recessionary gap

e) C = $600 + 0.75(Y – T)

I = $200

G = $0

T = $0

EX = $100

IM = 0.05Y

Y=$600 + 0.75(Y – 0)+200+100-0.05Y. Solving for Y, we get Y=3000

current level of GDP: $3000

Is there an inflationary gap, recessionary gap, or no gap : Recessionary gap