Question

Question 6 Unsaved Suppose a closed economy with no government spending or taxing initially. Suppose also that intended investment is equal to 150 and the aggregate consumption function is given by C = 250 + 0.75Y. And suppose that, if at full employment, the economy would produce an output and income of 3200 By how much would the government need to raise spending (G) to bring the economy to full employment? (round your answer to the nearest whole value

Answer 1

The components of aggregate demand (AD) are as follows: AD= C+I+G+NX where C: Consumption, I: Investment, G: Government Spending and NX: Net Exports. This example is that of a closed economy which means that there is no ‘net exports’ involved. From the given information, we know that the aggregate consumption function is given by C = 250 + 0.75Y. The intended investment is 150. Here Y is the income and output where Y=C+I+G+NX.

Initially without government or net exports,

Y= C+I

Or Y=250 + 0.75Y + 150

Or Y-0.75Y = 400

Or 0.25Y = 400

Or Y=1600.

Thus equilibrium level of income is Y=1600.

The formula of government expenditure multiplier is given by 1/(1-MPC) where MPC is the marginal propensity to consume which is equal to 0.75.

Thus, government expenditure multiplier = 1/1-0.75 = 1/0.25 = 4.

The change in income = change in government expenditure *the government expenditure multiplier.

That is

The full employment level of income and output is 3200. Thus the equilibrium level of income is less than the full employment level by 3200-1600 = 1600. This 1600 is the change in income. Therefore, putting the values in the above formula,

1600 = change in government expenditure* 4

Or change in government expenditure = 1600/4 = 400.

Thus, government spending has to raise by 400 in order to bring the economy to full employment.