Question

Assuming (initially) that there is no government spending or trade, an economy’s aggregate demand is given by its domestic consumption C and investment I, AD = C + I = c0 + c1Y + I. In the economy’s goods market equilibrium this equals its output: AD = Y. Solving for Y this yields:

Y = [1/(1  -c1 )] (c0+ I)

Given this equation, answer the following questions:

a. If the marginal propensity to consume is 0.6, how much is the multiplier in this economy?

b. Suppose that autonomous consumption is $1 bi and investment is $2 bi. How much is the total aggregate demand?

c. Now imagine that a lethal virus affects the society and firms become very pessimistic about the future of the economy. In response, they decide to cut investments by $1 bi. How much is Y after this initial reduction in investments?

d. Let's now introduce a government sector and assume and open economy. Government collect taxes T from the population and a fraction m of the total expenditure is on imports. What happens to the multiplier (increases, decreases, stays the same)?

Answer 1

a. Given equilibrium income, Y = C0 + C1Y + I
Marginal Propensity to Consume is given as 0.6. i.e. b = 0.6
Investment multiplie = 1/(1-b) = 1/(1-0.6) = 1/0.4 = 2.5
Fiscal multiplier = b/(1-b) = 0.6/(1-0.6) = 0.6/0.4 = 1.5

b. Assuming consumption is autonomously given. Thus it no longer depends on income. Thus C = $1 & Investment is also autonomously given at I = $2

Thus AD = C+I = $1+$2 = $3 bi

c. Now due to the effect of the virus investment is reduced by $1 and now I = $
No change in consumption is given. Thus C = $1
Hence AD = C+I = $1 + $1 = $2
Given in equilibrium AD = Y . Thus AD = Y = $2 due to the effect of the virus.

d. Nothing can be sain that as a result of imposing taxes how multiplier will change.