Question

1. Consider an economy with no international trade, no government spending and no taxes, whose consumption function and investment function are given by the following equations: C = 100,000 + .92Y I = 40,000

a. What is the equilibrium level of aggregate output for this economy?

b. What is the saving function for this economy?

c. Check the solution, as we did in class, by showing that at the equilibrium level of Y total spending exactly matches the level of output. At the equilibrium level of Y, what is the level of saving in the economy?

d. Sketch the solution in a graph. [BTW: PowerPoint has a very useful drawing program that will help you get good-looking diagrams; it is a good thing to know how to use. Go here for a basic tutorial: https://www.youtube.com/watch?v=M5X_zvh2j9Y. After constructing the diagram in PowerPoint you can cut & paste it into a Microsoft Word document.]

e. What is the Keynesian multiplier for this economy (see textbook, chapter 3)? If I increases by $2,000, what will be the new equilibrium level of Y?

2. Now let’s add Government Spending into the model. Government spending is a component of Aggregate Demand, just as Consumption Spending and Investment Spending. For now, let’s not worry about taxes; we can assume the government borrows to pay for all of its spending.

Consider a closed economy with no taxes, whose consumption function, investment level & government spending level are given by the following equations:

C = 5,000 + .80Y I = 9,000 G = 2000 where G represents government spending. The equilibrium condition is, as always, that the value of the economy’s output (Y) must be matched by aggregate demand, but now aggregate demand contains a third element, G. So the equilibrium condition from which we’ll start is now: Y = C + I + G.

a. What is the equilibrium level of aggregate output for this economy?

b. What is the saving function for this economy?

c. Check the solution, as we did in class, by showing that at the equilibrium level of Y total spending exactly matches the level of output. At the equilibrium level of Y, what is the level of saving in the economy?

d. Sketch the solution in a graph.

e. What is the Keynesian multiplier for this economy? If G decreases by $100, what will be the new equilibrium level of Y?

Answer 1

At equlibririm , AD = AS

AD = C + I + G + NX. But since here given G=0 and NX=0

AS = Y

So at equlibririm, Y = AD

Y= 100,000 + .92Y + 40,000

Y = 140,000 + .92Y

Y - .92Y = 140,000

.08Y = 140,000

Y = 140,000/.08

(a)  Y = 1,750,000

(b) saving function : S = Y - C

S = 1,750,000 - 100,000 + .92Y

S = 1,650,000 + .08Y. mps = 1- mpc

mps = 1-.92=.08