Question

In: Economics

Suppose that for a particular economy and period, investment was equal to 100, government expenditure was...

Suppose that for a particular economy and period, investment was equal to 100, government expenditure was equal to 75, net taxes were fixed at 100, and consumption (C) was given by the consumption function C = 25 + 0.8YD where YD is disposable income and Y is GDP.

a. What is the level of equilibrium income (Y).

b. What is the value of the government expenditure multiplier? Of the tax multiplier?

c. Suppose that investment declined by 40 units to a level of 60. What will be the new level of equilibrium income? __________

4. In the question above, assume that beginning from the initial equilibrium position (investment equal to 100, government expenditure equal to 75, and net taxes fixed at 100), there was an autonomous fall in consumption and an increase in saving such that the consumption function shifted from C = 25 + 0.8YD to C = 5 + 0.8YD

a. Find the change in equilibrium income resulting from the autonomous increase in saving.

b. Calculate the level of saving before and after the shift in the consumption and, therefore, the saving function. How do you explain this result?

Solutions

Expert Solution

Ans.

a) Aggregate Expenditure, AE = Consumption + Investment + Government expenditure

=> AE = 25 + 0.8*(Y - Net Taxes) + 100 + 75

=> AE = 120 + 0.8Y

At equilibrium,

Y = AE

=> Y = 120 + 0.8Y

=> Y = $600

Thus, equilibrium income is $600

b) From the consumption function, we get,

Marginal Propensity to Consume, MPC = 0.8

=> Government expenditure multiplier = 1/(1-MPC) = 1/(1-0.8) = 5

and tax multiplier = -MPC/(1-MPC) = -0.8/(1-0.8) = - 4

c) New level of income = (1/(1-MPC)) * (Change in investment) + Old income

=> New income level = (1/(1-0.8))*(-40) + 600 = $400

d) Decrease in autonomous consumption = -$20

Change in equilibrium income = (1/(1-0.8))* Change in autonomous consumption = -$100

Thus, new equilibrium income = 600 - 100 = $500

e) Savings function = Before Income - Consumption = 600 - 25 - 0.8(Y - 100) = 495 - 0.8Y

Thus, savings before = 495 - 0.8*600 = $15

Savings after = 495 - 0.8*(500) = $95

Tahnk you

Rahul Sunny answered 2 years ago
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