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

Question

Assume that all expenditure is summarized in the following consumption and investment functions: ( 15 pts. ) [Hint: Review Chapters 9, Equilibrium GDP formulae ,10, and 11 . You have to use a little of your algebra knowledge for this question along with economics from these chapters . you will have to figure out the numbers in all parts except part b for full credit.] C = $200 billion + 0.8 YD I = $200 billion Use this information to complete this problem: (2.5 points for each part ) Identify the equilibrium rate of output (or GDP) . If full-employment GDP equals $2600 billion ,what kind of Gap will develop (recessionary or Inflationary ) ? Explain clearly. How much is the gap ? What is the value of the multiplier? What would happen to equilibrium GDP if the rate of investment increased to $300 from current $200 billion per year? If net exports go up by $20 billion what would happen to Equilibrium GDP?

Explanation / Answer

(i) In equilibrium, Y = C + I

Y = 200 + 0.8Y** + 200 [Since Yd = Y - T (tax), but tax is not mentioned, we assume T = 0]

(1 - 0.8)Y = 400

0.2Y = 400

Y = $2,000 billion

(ii) Since equilibrium GDP (Y) < Full-employment Y, there is a recessionary gap.

Recessionary gap ($ Billion) = Full-employment Y - Equilibrium Y = 2,600 - 2,000 = 600

(iii) MPC = 0.8, therefore multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

(iv) Increase in investment ($ Billion) = 300 - 200 = 100

Increase in GDP ($ billion) = Increase in investment x Multiplier = 100 x 5 = 500

New value of GDP ($ billion) = 2,000 + 500 = 2,500

(v) When net exports increase by $20 billion,

Increase in GDP ($ billion) = Increase in net exports x Multiplier = 20 x 5 = 100

New value of GDP ($ billion) = 2,000 + 100 = 2,100

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