Question

1. Consider the Aggregate Expenditure Model (AKA the Multiplier Model where prices are fixed) for a closed private economy.  What are the categories of expenditure? What determines the slope of the AE function? Why is the intersection of the AE and the 45-degree line the equilibrium? To answer the last part tell me what is happening with inventories if you are at a GDP level below the equilibrium and why that pushes the economy toward equilibrium.

2. What are the leakages and injections in the scenario from #1 and what equation holds between them in equilibrium?  

3. Now assume that we have an MPC of .8 and the economy in # 1 faces a sudden investment expenditure increase of $100.  If the initial equilibrium is at a real GDP level of $2000 then what will the new equilibrium be? How much will the equilibrium level of output and expenditure change?  Show the diagram for this scenario.   

4. What are the leakages and injections for a private OPEN economy? How do they balance in equilibrium? Show the equation.

Answer 1

Closed economy category of expenditure: i) consumption expenditure ii) government spending iii) Investment expenditure.

Marginal propensity to consume determine the slope of AE( aggregate EXPENDITURE).

45° degree shows aggregate supply and AE line shows aggregate demand so economy is Equilibrium at aggregate demand= aggregate supply.if economy is below than that point, it means aggregate expenditure or aggregate demand is higher than output,so it will lead to decrease in inventory. To maintain the same level of inventory,firms Increase Production and economy reachs at Equilibrium at Intersection of AE and 45° degree line.

Injection are that Increase circular flow of income. Example= Investment, government spending

Leakage are that Decrease circular flow of income.example= tax, private saving

In Equilibrium leakage= injection.

Investment multiplier=1/(1-mpc)=1/(1-0.8)=1/0.2=5

So Increase in gdp=100*5=500

New Equilibrium gdp=2000+500=2500

In open economy leakage= Import+private saving+ taxes

Injection= Investment+ government spending+ Exports

In Equilibrium , leakage= injections