Question

1. Consider the following model of the economy:

C = 170+.6(Y-T)

I = 250

G = 300

T = 200a.

What is the value of the marginal propensity to consume?b. What is the value of the government budget deficit?c. Calculate the equilibrium level of GDP and show you work on a Keynesian-Cross diagram.d. What is the value of the government-purchases multiplier? Show all your work and explain fully.e. Use your answer to part d to calculate the amount by which government purchases of goods and services would have to rise in order to increase the equilibrium level of GDP by 50. Show this work on the diagram you drew for part c.

Answer 1

a) MPC is the slope of the consumption function. For the given case consumption function has a slope of 0.6. Hence MPC is 0.6

b) Government budget has an equation of revenues - spending. Here revenues (taxes) are 200 while spending is 300. Hence budget deficit amounts to 100

c) At equilibrium, PAE = Y

170 + 0.6(Y - 200) + 250 + 300 = Y

170 + 0.6Y - 120 + 250 + 300 = Y

600 = 0.4Y

YE = 1500.

This is the equilibrium level of GDP. It is shown by point A

d. Government-purchases multiplier is given by = 1/1-MPC(1-t) where t is used when taxes are proportiona. Here t=0 so the multiplier is = 1/1-0.6 = 2.5.

.e. The amount by which government purchases of goods and services would have to rise in order to increase the equilibrium level of GDP by 50 is given by

Y/G = multiplier

50/G = 2.5

G = 50/2.5 = 20.

Hence the required increase in government spending is 20.