Question

Consider that an average Supposistan consumer saves 25 percent of his or her disposable income.

a)         Write down the consumption function for Supposistan.

b)        Write down the condition for the demand-side (short-run) equilibrium for Suppsosistan.

c)         Obtain the multiplier for this economy.

d)        Calculate the equilibrium level of income in the short-run if the planned investment, government spending and net exports amount to 5,000 and net tax (taxes-transfers) is 1,200.

e)         Explain what happens if Y is actually realized at the level of 20,000 ?

Answer 1

a) Let the income be Y, and disposable income, which is income minus taxes and adding trandfer payment be Yd.

Thus, Yd= Y- T+Tr

T= Taxes

Tr= transfer payments

The Supposistan consumer consumes 25% of his disposable income. Thus, the marginal propensity to consume of the consumer is 0.25.

The consumption function of the consumer can be written as:

C= a+0.25Yd

C= a+0.25( Y- T+Tr)

a= Autonomous consumption.

b) The economy would be in equilibrium, when,

Y= C+I+G +(X-M)

C= consumptuion function

I= Investment

G= government expenditure.

X-M= Net exports

c)The formula for the expenditure multiplier in the economy is given as:

Here, b= marginal propensity to consume which is equal to 0.25.

Thus, the government expenditure multiplier becomes= 1/1-0.25= 1/0.75= 1.34

d) The equation for equilibrium can be wiritten as:

Y= C+I+G+(X-M)

Y= a+0.25( Y- T+Tr) +I+G+(X-M)

It is given that,

I+G+(X-M) = 5000

and, T-Tr= 1200

Thus, the equilibrium income becomes,

Y= 0.25(Y- 1200) +5000

0.75Y= 4700

Y= 6266.67