Assume that the consumption schedule for a private open economy is such that con

Question

Assume that the consumption schedule for a private open economy is such that consumption C = 40 + 0.75Y. Assume further that planned investment (Ig) and net exports (Xn) are independent of the level of real GDP and constant at Ig = 50, G =30 and Xn = 15. Recall also that, in equilibrium, the real output produced (Y) is equal to aggregate expenditures: Y = C + Ig + G+ Xn. a. Calculate the equilibrium level of income or real GDP for this economy. b. What happens to equilibrium Y if G changes to 40? What does this outcome reveal about the size of the multiplier? What does this outcome reveal about the impact of fiscal policy?

Explanation / Answer

(a) Y = C + Ig + G + Xn

Y = 40 + 0.75Y + 50 + 30 + 15

(1 - 0.75)Y = 135

0.25Y = 135

Y = 540

(b) G = 40

Y = 40 + 0.75Y + 50 + 40 + 15

0.25Y = 145

Y = 580

So, as G increases by (40 - 30) = 10, Y increases by (580 - 540) = 40.

Spending multiplier = Change in Y / Change in G = 40 / 10 = 4

This means that fiscal policy is highly effective in changing the real GDP of the economy. If spending increases (decreases) by $1, real GDP increases (decreases) by $4.

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