Question

For a specific model where the consumption function is given as C=100+0.75y, while investment is 60, with no government purchases and no net exports,

a) find the equilibrium level of income

b) find the level of savings

c) if for some reason output is at the level of 700 what will the level of unplanned inventory be?

d) if I rises to 80 what will the effect be on the equilibrium income?

e) what is the value of the multiplier , a, here?

f) draw a diagram indicating the equilibrium

Answer 1

(a)

In equilibrium, Y = C + I

Y = 100 + 0.75Y + 60

0.25Y = 160

Y = 640

(b)

C = 100 + 0.75 x 640 = 100 + 480 = 580

Saving = Y - C = 640 - 580 = 60

(c)

Unplanned inventory = 700 - 640 = 60

(d)

When I = 80,

Y = 100 + 0.75Y + 80

0.25Y = 180

Y = 720

So, I increases by (720 - 640) = 80.

(e)

Multiplier = Change in Y / Change in I = 80 / (80 - 60) = 80 / 20 = 4

(f)

In following graph, planned aggregate expenditure (PAE) and real GDP (Y) are measured vertically and horizontally respectively. Initial Equilibrium is at point A where 45⁰ line intersects initial aggregate expenditure curve PAE0, with equilibrium GDP Y0 and planned aggregate expenditure E0.

When investment increases from I0 to I1, the PAE0 line shifts up to PAE1. New Equilibrium is at point B where 45⁰ line intersects new planned aggregate expenditure curve PAE1, with higher equilibrium GDP Y1 and higher planned aggregate expenditure E1.