Question.3189 - Suppose for a closed economy (no import or export) , the autonomous consumption (AC) =500, MPC=0.9, and suppose that the investment I =300, Government spending G= 400 and tax =400 A.) Write the specific consumption function: C= and write the aggregate demand function AD= B.) Write the equation to describe the market in equilibrium: C.)What is the GDP – Ye in the equilibrium? D.) If the potential GDP Yp= 8000, and the government decided to use fiscal policy (increase government expenditures) to increase the GDP to its potential level. With the multiply effect, how much government spending should be increased so to bring the economy back to full employment GDP? E.) If the government did conduct the expansionary fiscal policy to raise the GDP, how will the government budget change. F.) If the government decided to use fiscal policy to cut tax, thus to stimulate the economic growth. How much tax should it cut to bring the GDP to its potential full employment GDP- Yp=8000? Which fiscal policy is more effective and efficient without serious side effects? Explain it.
Answer Below:
Given: autonomous consumption (AC) =500, MPC=0.9, investment I =300, Government spending G= 400 tax =400 A) The Consumption function is given by following equation C= 500+0.9 (Y-400) C= 500-360 + 0.9Y C= 140 + 0.9Y The aggregate demand function is given by the equation Y= C+I+G Y= 140 + 0.9Y + 300 +400 Y= 840 + 0.9Y……………………………………… (1) B) The market equilibrium is given by Y= 840 + 0.9Y. C) Solving equation 1 0.1Y= 840 Y=8400 D) Given Y p = 8000. The government expenditure multiplier is 1/ 1-0.9 = 1/ 0.1 = 10 = dY / dG . So the increase in increase in income (dy) is 10 times the increase in government spending. (dG) E) If the government did not undertake the expansionary fiscal policy, the budget would change if and only if investment was not autonomous. That is investment then would have to be a function of aggregate demand. I= I (Y) the tax multiplier will be (-0.9/ 1-0.9) = - 0.9 /0.1 = -9 = dY/ dT So the decrease in increase in income (dy) is 9 times the increase in taxes (dT). Government spending is more effective. An increase in the tax level would reduce the disposable income of the economy. A similar increase in the government spending would however increase the aggregate demand in the economy.More Articles From Economics
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