Question

1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The largest component of GDP is consumption.

b. Government spending, including transfers, was equal to 18.1% of GDP in 2014.

c. The propensity to consume has to be positive, but other- wise it can take on any positive value.

d. One factor in the 2009 recession was a drop in the value of the parameter c0.

e. Fiscal policy describes the choice of government spend- ing and taxes and is treated as exogenous in our goods market model.

f. The equilibrium condition for the goods market states that consumption equals output.

g. An increase of one unit in government spending leads to an increase of one unit in equilibrium output.

h. An increase in the propensity to consume leads to a de- crease in output.

2. Suppose that the economy is characterized by the following behavioral equations:

C = 160 + 0.6YD

I = 150 G = 150

T = 100

Solve for the following variables.

a. Equilibrium GDP (Y)

b. Disposable income (YD)

c. Consumption spending (C)

3. Use the economy described in Problem 2.

a. Solve for equilibrium output. Compute total demand. Is it equal to production? Explain.

b. AssumethatGisnowequalto110.Solveforequilibrium output. Compute total demand. Is it equal to production? Explain.

c. Assume that G is equal to110,so output is given by your an- swer to part b. Compute private plus public saving. Is the sum of private and public saving equal to investment? Explain.

Answer 1

1. a. The largest component of GDP is consumption - True

b. Government spending, including transfers, was equal to 18.1% of GDP in 2014 - False, government spending excluding transfers was 18.1% of GDP in 2014.

c. The propensity to consume has to be positive, but otherwise it can take on any positive value - False, the propensity to consume must be less than one. Therefore, it cannot take just any positive value. Because every person will consume only a part of the increase in the disposable income.

d. One factor in the 2009 recession was a drop in the value of the parameter c0 - True.

e. Fiscal policy describes the choice of government spending and taxes and is treated as exogenous in our goods market model - True, fiscal policy describes the decisions of the government spending in light of the tax component.

f. The equilibrium condition for the goods market states that consumption equals output - False, aggregate demand has to be equal to aggregate output.

g. An increase of one unit in government spending leads to an increase of one unit in equilibrium output - False, because an increase of one unit in government spending leads to output increase by a factor of more than one.

h. An increase in the propensity to consume leads to a decrease in output - False, according to the marginal propensity to consumption theory, the propensity to consume leads to increase in output.

2. C = 160 + 0.6Y_D
I = 150
G = 150
T = 100

Equilibrium GDP (Y) = C+I+G (And Disposable Income (Y_D) = Y-T)
Y = 160 + 0.6Y_D + 150 + 150
Y = 160 + 0.6 (Y-100) + 150 + 150
Y = 160 + 0.6Y - 60 + 300
0.4Y = 400
Y = 1000

Therefore, disposable income can be calculated using Y = 1000
Disposable Income (Y_D) = Y-T
Y_D = 1000 - 100
= 900

Consumer spending (C) = 160 + 0.6Y_D
= 160 + 0.6*900
= 700

3. a. Equilibrium Output (Y) = C+I+G
= 700 + 150 + 150
= 1000
Total Demand (Z) = C+ I + G
= 700 + 150 + 150
= 1000
At equilibrium, output and demand are equal. In equilibrium, the demand (Z), which depends upon income (Y), is equal to production.

b. Equilibrium GDP (Y) = C+I+G (And Disposable Income (Y_D) = Y-T)
Y = 160 + 0.6Y_D + 150 + 150
Y = 160 + 0.6 (Y-100) + 150 + 110
Y = 160 + 0.6Y - 60 + 260
0.4Y = 360
Y = 900

c. Y_D = Y - T
= 900 - 100
= 800

C = 160 + 0.6Y_D
= 160 + 0.6*800
= 640

Private Spending = Y - C - T
= 900 - 640 - 100
= 160

Public Spending = T - G
= 100 - 110
= (-10)

Private Spending + Public Spending = 160 + (-10)
= 150

Total Savings are private plus public savings, which is equal to 150, also equal to investment. In equilibrium, the demand equals the production, which means that investment will be adequately financed through savings. If the two are not equal, we will not be in equilibrium.