Question

Income-Expenditure Model

Consider an economy with the following economic agents:

• Households/Consumers who earn income from the factor market, pay taxes to the government, purchase goods and services from firms in the market for goods and services, and save money in the loanable funds market
  • Households spend $10,000 when they have no income
  • Households save 20% of any increase in their disposable income
  • Consumer behavior is characterized by the equation C = A + mpc x Y_D
• Firms/Producers who pay households in the factor market, sell to households and the government in the market for goods and services, and engage in investment spending using money borrowed in the market for loanable funds
  • Firms plan to buy $5,000 worth of physical capital and have $15,000 in unsold inventory
  • Firm investment spending is characterized by the equation I = I_Planned + I_Unplanned
• The Government who receives taxes from consumers, buys goods and services from firms in the market for goods and services, and saves or dissaves in the market for loanable funds
  • The government receives $5,000 in taxes
  • The government buys $30,000 worth of goods and services
  • There are no social safety nets in the economy, so the government does not pay any social security payments, unemployment payments, etc
• The economy is a closed economy

1. What are the two other assumptions we need to model this economy using the income – expenditure model?

2. What equation characterizes disposable income in the economy?

Y_D =

3. What equation characterizes total output in the economy?

   Y = GDP =

4. What equation characterizes planned spending?

   AE_Planned =

5. What is the equilibrium condition in the income – expenditure model?

6. Solve for equilibrium and fill out the following chart.

Variable	Equilibrium Value
Y
C
I

7. Solve for the following variables and fill out the chart with the corresponding value:

Government Budget Balance
Private Savings
National Savings

8. Draw the graph of the income – expenditure (Keynesian cross) model. Make sure you label everything. Then show on your graph what would happen if the government decided to increase their expenditure on goods and services.

Answer 1