Question

 

Please be advised this was the information provided to me for a "hypothetical economy"

Please see below the spending information pertaining to the participants of a hypothetical economy.

C = $10 + 0.8Y               

I = $20                

G = $30               

X-M = $10

1. State the name of the economic agent/participant that each equation above would apply to.
2. State the assumptions underlying the equations for C and I. Why do we make these assumptions?
3. Draw a graph to illustrate the desired aggregate expenditures of an economy whose participants have the spending plans provided above.
4. Calculate the value of equilibrium output.

Answer 1

Below are the agents that apply to each equation:

C = $10 + 0.8Y : Underlying economic agents are Households

I = $20 : Economic agents are firms and investors

G = $30 : Participant is the Government

X-M = $10 : Firms and Industries

Assumption for Consumption function:

- Function is assumed to be stable and static

- Expenditure is determined by the national income

- Positive relationship between national income and consumption

- Marginal Propensity to Consume is always postive

- Some consumption is still possible even if income = 0

Assumption for Investment function:

- the demand for investment is exogenous in the model

- a constant representing money invested each year

These assumptions are made so that the economy reaches to a static equilibrium where there is balance in the goods market. If MPC is not assumed to be static then equilibrium becomes dynamic and the classical theory would fail to predict changes in the national income due to change in spending behaviours

At equilibrium AE = Y

Y = C + I + G + NX

Y = 10 + 0.8Y + 20 + 30 + 10

0.2Y = 70

Y* = 350 : equilibrium output