Assume that all expenditure is summarized in the following consumption and inves

ID: 1119434 • Letter: A

Question

Assume that all expenditure is summarized in the following consumption and investment functions:

C = $300 billion + 0.8 YD I = $200 billion

Use this information to complete this problem:

a. Identify the equilibrium rate of output (or GDP) .

b. If full-employment GDP equals $2400 billion ,what kind of Gap will develop (recessionary or Inflationary ) ? Explain clearly.

c. How much is the gap ?

d. What is the value of the multiplier?

e. What would happen to equilibrium GDP if the rate of investment increased to $250 from current $200 billion per year?

f. What will happen to Equilibrium GDP if Govt. takes a stimulus plan by increasing its spending by $50 billion ?

(a) In equilibrium, Y = C + I

Y = 300 + 0.8Y + 200

(1 - 0.8)Y = 500

0.2Y = 500

Y ($ Billion) = 2,500

(b) Since equilibrium GDP is higher than full employment GDP, there is an inflationary gap.

(d) MPC = 0.8 From consumption function)

Multiplier = 1 / (1 / MPC) = 1 /(1 - 0.8) = 1 / 0.2 = 5

(e) When I = $250 billion,

Y = 300 + 0.8Y + 250

(1 - 0.8)Y = 550

0.2Y = 550

Y ($ Billion) = 2,750

Increase in Y ($ Billion) = 2,750 - 2,500 = 250

(f) When G rises by $50 billion,

Increase in Y ($ Billion) = Increase in G x Multiplier = 50 x 5 = 250

New level of Y ($ Billion) = 2,500 + 250 = 2,750

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