Question

1. Suppose the economy includes only consumers and businesses (no government or international trade).  In this private-sector economy, spending behavior is represented by:

                            C = $300 + 0.6Y_D                  I_g = $500

         

a) Use this information to complete the following table:

                                                                                             (part d)

Income (y_D)     C        +       I_g     =   Aggregate expenditures    Aggregate expenditures (I_g=600)

        $1,000            ______     ______          ____________                 ____________

        1,500         ______     ______      ____________                 ____________

        2,000         ______     ______      ____________                 ____________

        2,500         ______     ______      ____________                 ____________

        3,000         ______     ______      ____________                 ____________

b)  When Ig equals $500 where is equilibrium?  ______________________

c)  If full employment output is $3,000, what kind of gap exists?  How large is it?

d) When Investment increase to $600 where is the new equilibrium? _____________

e) With the increase in investment, what has happened to the full employment gap?

f) In the equation C = $300 + 0.6Y_D

what does 300 represent?

what does .6 represent?

2. If the consumption function is C = $250 + 0.8Y_D, what is the level of savings when disposable income equals:

         a) $500 ?   __________        

         b) $1,000 ? __________

         c) $1,500 ? __________

Answer 1

1)

Income (Yd)	C	Ig	Aggregate expenditure (when Ig=500)	Aggregate expenditure (when Ig =600)
1000	900	500	1400	1500
1500	1200	500	1700	1800
2000	1500	500	2000	2100
2500	1800	500	2300	2400
3000	2100	500	2600	2700

C = 300 + 0.6Yd

Aggregate expenditure = C + Ig

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(b) At equilibrium; Income = Aggregate expenditure

Hence, the equilibrium level of income is $2000 when Ig is $500

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(c) full employment output is $3000

Equilibrium output is $2000

Equilibrium output is less than full employment output by $1000. It means there is a recessionary gap of $1000.

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(d) Now Ig = 600

There is increase in Ig by 100. An increase in investment by 100 will lead to increase in autonomous spending by 100.

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C = 30 + 0.6Yd

=>MPC = ΔC / ΔYd

=> MPC = 0.6

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Spending multiplier = 1 / (1-MPC)

=> Spending multiplier = 1 / (1-0.6)

=> Spending multiplier =1 / 0.4

=> Spending multiplier = 2.5

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Spending multiplier = (change in equilibrium output / change in autonomous spending)

=> 2.5 = Change in equilibrium output / 100

=> Change in equilibrium output = 2. 5 *100

=> Change in equilibrium output = 250.

hence, the equilibrium outout will increase by 250.

New equilibrium output= 2000 + 250

=> New equilibrium output = 2250.

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(e)

full employment output is $3000

New Equilibrium output is $2250

Equilibrium output is less than full employment output by $750. It means there is a recessionary gap of $750.

Due to increase in investment, the recessionary gap decreases from $1000 to $750

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(f)

C = 300 + 0.6Yd

300 represents the autonomous consumption, i.e..the consumption at zero level of disposable income

0.6 represents the value of MPC, which measures the change in consumption due to change in disposable income.

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Question 2:

(a)

C = 250 + 0.8Yd

=> Put Yd = 500

=> C = 250 +0.8(500)

=> C = 650

and

Yd = C+S

=>500 = 650 +S

=>S = -150

The saving is -150

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(b)

C = 250 + 0.8Yd

=> Put Yd = 1000

=> C = 250 +0.8(1000)

=> C = 1050

and

Yd = C+S

=>1000= 1050+S

=>S = -50

The saving is -50

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(c)

C = 250 + 0.8Yd

=> Put Yd = 1500

=> C = 250 +0.8(1500)

=> C = 1450

and

Yd = C+S

=>1500 = 1450 +S

=>S = 50

The saving is 50