Solve E Goods market: Y = C + I + G + NX C = 600 + 0.75*DI (DI: disposable incom

Question

Solve E

Goods market:

Y = C + I + G + NX

C = 600 + 0.75*DI (DI: disposable income = Y - T)

I = 1000 - 2000*r (r: inerest rate)

G = 1100

NX = 600 - 0.1*Y

T = 0.2*Y (a proportional income tax system)

Money market:

Real money supply: ( MP )S = 1000

Real money demand: ( MP )d = 2500 - 10000*r1 (r: inerest rate)

Suppose the potential GDP (i.e., the maximum amount of product an economy can produce; it’s also called full-employment GDP tha corresponds to the NRU) equals 6400,

Y = 3,000 + 0.5 (6,400)

    = 3,000 + 3,200

    = 6,200

E) How large is the new govement spending needed to achieve the potential level of GDP? [Hint: Equate money supply with demand to solve for interest rate r. Substitute r to investment equation to find I. Add up C, I, G and NX to find total spending, which is a function of Y. Equate this spending equation with Y to find equilibrium GDP (i.e., solve for Y).]

Explanation / Answer

At equilibrium Money Supply = Money Demand

1000 = 2500 - 10000 x r

10000r = 1500

r = 0.15 or 15%

I = 1000 - 2000 x 0.15 = 700

DI = Y - T

Y = 6400

T = 0.2 x 6400 = 1280

DI = 6400 - 1280 = 5120

C = 600 + 0.75 x 5120 = 4440

NX = 600 - 0.1 x 6400 = -40

Y= C + I + G + NX

6400 = 4440 + 700 + G - 40

G = 6400 - 4440 - 700 + 40 = 1300

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