Question

Assume that in​ 2015, the following prevails in the Republic of​ Nurd:

Government spending​ (G) =​ $0

Net taxes​ (T) =​ $0

Planned investment​ (I )​ = ​$ 30

Assume that households of Nurd consume 80 percent of their​ income; they save 20 percent of their income. In other​ words, their MPC​ = .80 and MPS​ = .20 ​Thus, the consumption function and saving function of Nurd​ are:

C​ = .80Y^d and S​ = .20Y^d ​, where disposable income Y^d ​= Y-T

​Currently, the economy of Nurd is in equilibrium. As the leading econometrician of​ Nurd, you have estimated the​ full-employment level of income for the economy to be ​$200.

Calculate the adjustment in government​ spending, if​ any, to achieve full employment in Nurd.

Δ G=

Answer 1

At equilibrium point in closed economy: Y = C + I + G

=> Y = 0.80Yd + 30 + 0

Note: Yd = Y - T

=> Y = 0.80 (Y-T) + 30

=> Y = 0.80 (Y -0) + 30

=> Y = 0.80Y + 30

=> Y -0.80Y = 30

=> 0.2Y = 30

=> Y = (30 /0.2)

=> Y =150

Equilibrium level of income is 150.

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The full employment level income is 200.

The equilibrium level of income is less than full employment level of income by 50. It means there is an recessionary gap of 50.

In order to close this gap, there is an need to increase the equilibrium level of income by 50.

=> Change in equilibrium level of income = 50

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In order to increase the equilibrium level of income, government spending should be increase.

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MPC = 0.8

Government spending multiplier = 1 / (1-MPC)

=> Government spending multiplier =1 / (1-0.8)

=> Government spending multiplier = (1/0.2)

=> Government spending multiplier = 5

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=> Government spending multiplier = (change in equilibrium level of income / change in government spending)

=> 5 = (50 / change in government spending)

=> Change in government spending = (50 / 5)

=> Change in government spending = 10

In order to achieve the full employment level of income, there is a need of increase in equilibrium level of income by 50, which can be increased by raising the government spending by 10.

Answer: Δ G= 10

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