Question

1)Suppose the Canadian economy is at its long-run equilibrium with national income equal to the potential national income.

a) Suppose there is an increase in government purchases (G). Use ALL diagrams to show the effect of an increase in government purchases (G) on aggregate demand. Are equilibrium price and national income higher or lower at the new short-run equilibrium?

b)Suppose there is a decrease in wealth (W) because of a price change. Use ALL diagrams to show the effect on aggregate demand. Are equilibrium price and national income higher or lower at the new short-run equilibrium?

2)Consider the following features for an economy:

C =110+ 0.7YD,

I =200, G =650, T = 0.2Y,

X =50, IM = 0.04Y

a)What is the aggregate expenditure function for this economy?

b) What is the marginal propensity to spend? (1 mark)

c) Find the multiplier.

d) Calculate the equilibrium level of national income for the economy.

Answer 1

(1)

In each graph, the Keynesian cross model, planned aggregate expenditure (PAE) and real GDP (Y) are measured along vertical and horizontal axes respectively. G0 and PAE0 are initial government spending and planned aggregate expenditure curves (where PAE0 = C0 + I0 + G0). Initial equilibrium is at point A where PAE0 intersects 45⁰ line with initial real GDP Y0. In the AD-AS model, AD0 and AS0 are initial aggregate demand and short-run aggregate supply functions intersecting at point A with initial price level P0 and GDP (national income) Y0.

(a)

Increase in government spending will increase planned aggregate expenditure, which will shift G0 upward from G0 to G1 which will increase PAE, shifting PAE0 upward to PAE1. New equilibrium is at point B where PAE1 intersects 45⁰ line with higher national income Y1. In the AD-AS graph, higher government spending will increase aggregate demand, shifting AD0 curve rightward to AD1, intersecting AS0 at point B with higher price level P1 and higher national income Y1.

(b)

Decrease in wealth will decrease consumption, which will decrease planned aggregate expenditure, thus shifting C0 downward from C0 to C1 which will decrease PAE, shifting PAE0 downward to PAE1. New equilibrium is at point B where PAE1 intersects 45⁰ line with lower national income Y1. In the AD-AS graph, lower consumption demand will decrease aggregate demand, shifting AD0 curve leftward to AD1, intersecting AS0 at point B with lower price level P1 and lower national income Y1.

NOTE: As per Answering Policy, 1st question is answered.