Question

3. Consider a closed economy named ‘Seewhyland’ which always keeps its trade with foreign countries in balance. It is dollarized like Ecuador or Zimbabwe.

People in this economy tend to save 25 cents for every dollar increase in their disposable income and spend $100B when there is no disposable income.

Also, you were also given the following data about the economy:

Government budget surplus = $100B;

Government purchase = $300B;

Private saving = $250B.

Based on this information, please answer the following questions.

3.1. Set up the consumption function of this economy. Then using the goods market equilibrium condition, compute the private investment (I*) of this country when the goods market is in equilibrium. Then, solve for the equilibrium real GDP (Y*), the equilibrium consumption (C*).

3.2. Explain what happens to the equilibrium real GDP when the government decreases its purchase and tax collection by $100B.

Answer 1

(3.1) People in this economy tend to save 25 cents for every dollar increase in their disposable income and spend $100B when there is no disposable income.

=> MPS = 0.25

=>MPC = 1 - MPS
=>MPC = 1 - 0.25

=>MPC = 0.75

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Autonomous consuption (C0) = 100

Consumption function: C = C0 + MPC*(Yd)

Where Yd is disposable income

=>C = 100 + 0.75Yd

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Government budget surplus = Taxes (T) - Government purchases(G)

=> $100B = Taxes (T) - $300B

=> Taxes(T) = $100B + $300B

=>Taxes (T) = $400B.

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Public saving = Taxes - Government purchases

=> Public saving = $400B - $300B

=> Public saving = $100B

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Private saving = $250B

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National Saving = Public saving + Private saving

=> National Saving = $100B + $250B

=> National Saving = $350B

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At good market equilibrium point (in closed economy), National saving = Private investment

=> Private investment = $350B

=> I* = $350B

Equilibrium private investment (I*) is $350B

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At equilibrium, Y = C+I+G

=>Y = 100 + 0.75Yd + 350 + 300

=> Y = 750 + 0.75 (Y -T)

=> Y = 750 + 0.75(Y-400)

=> Y = 750 + 0.75Y - 300

=> Y - 0.75Y = 450

=> 0.25Y = 450

=> Y = (450 / 0.25)

=> Y = 1800

Equilibrium real GDP (Y*) = $1800B

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C = 100 + 0.75Yd

=> C = 100+ 0.75 (Y-T)

=> C = 100 + 0.75(1800 - 400)

=> C = 100 + 1050

=> C = 1150

Equilibrium consumption (C*) = $1150B

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(3.2)According to balanced budget multiplier,

• An equal increase in government purchases and taxes result in a net increase in equilibrium real GDP
• An equal decrease in government purchases and taxes result in a net decrease in equilibrium GDP.

So, if government decreases its purchases and tax collection by $100B, then accordiing to balanced budget multiplier concept, the equilibrium real GDP will decrease by $100B