Wednesday 21 October

Suppose we have a Keynesian economy in which output (real GDP) is well below the full employment level.

Y = real GDP = $800 billion

C = consumption = $600 billion

G = government real purchases = $100 billion = T, taxes

I = investment = $100 billion = S, saving.

There is no foreign trade. The marginal propensity to consume is 0.75, i.e. 75 cents of each extra $1 of income is spent on consumption. Taxes do not vary with income.

  1. Is this economy in macroeconomic equilibrium?

    2. Yes. Because real GDP (output) is $800 billion, and Aggregate Expenditure (C + I + G) [no foreign trade, remember] is $ 600 + 100 + 100 = $800 billion, Y = AE, we are in equilibrium.

  2. If G is increased by $25 billion, with no change in T, what would be the immediate effect on consumption?

Immediately, AE is up $25 billion, so output and income are up $25 billion, so consumption is up mpc times (change in income), which is 0.75 x $25 billion equals $18.75 billion.

c) What is the multiplier in this economy?

Multiplier is [1/(1 - mpc)], i.e. one divided by (1 - 0.75), 1/(.25), equals 4.

d) What is the new equilibrium level of Y?

Initial change in spending on output is $25 billion;

Change in equilibrium spending and output is initial change times the multiplier, i.e. 4 x $25 billion equals $100 billion;

So new equilibrium is 800 + 100 = $900 billion.