Global and Domestic Macroeconomics Problem 1. We know the following about a coun

Question

Global and Domestic Macroeconomics

Problem 1. We know the following about a country called Fribonia: Co=10,000 C1=0.8 T=10,000 Tr=2,500 G=7,500 I=5,000 QUESTIONS: (a) Formulate the corresponding macroeconomic model identifying each of its equations. (b) Show that the equilibrium output level is 82,500 (c) What would happen with the economy of this country if Government spending increases in 3,000 units? (d) If all the workers in the economy are working when output is 100,000, what would have been the adequate increase in government spending to get output move to full employment level. What other things could the government have done? (e) What other fiscal policy tools could the Government use to attain its goal of full employment? Do all these policies affect all economic agents equally?

Explanation / Answer

(a) The model is:

GDP (Output) = Consumption (C) + Investment (I) + Government spending (G), where

C = C0 + C1(Y - T + Tr)

So,

Y = C0 + C1(Y - T + Tr) + I + G

(b) Plugging in given values:

Y = 10,000 + 0.8(Y - 10,000 + 2,500) + 5,000 + 7,500

Y = 22,500 + 0.8(Y - 7,500)

Y = 22,500 + 0.8Y - 6,000

(1 - 0.8)Y = 16,500

0.2Y = 16,500

Y = 82,500

(c)

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

So, as government spending increases by 3,000, real GDP (Y) increases by 3,000 x 5 = 15,000

(d)

If government spending when Y = 100,000 be G, then

100,000 = 10,000 + 0.8(100,000 - 10,000 + 2,500) + 5,000 + G

85,000 = 0.8 x 92,500 + G

85,000 = 74,000 + G

G = 11,000

Increase in government spending = 11,000 - 7,500 = 3,500

Otherwise, the government could lower the tax (T) to achieve a higher level of Y.

Note: First 4 sub-parts are answered.

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