Question

Consider a small economy that is closed to trade, so its net exports are equal to zero. Suppose that the economy has the following consumption function, where C is consumption, Y is real GDP, I is investment, G is government purchases, and T stands for net taxes:

C= 25 + 0.75∗ (Y−T).

Suppose G = $130 billion, I = $60 billion, and T = $20 billion.

Given the consumption function and the fact that, in a closed economy, total expenditure can be calculated as Y=C+I+GY=C+I+G, the equilibrium output level is .......................... billion.

Suppose the government purchases are reduced by $100 billion. The new equilibrium level of output will be equal to $............................. billion.

Based on the effect of the change in government purchases on equilibrium output, you can tell that this economy's spending multiplier is equal to ...................................

Answer 1

1. The Equilibrium Output level can be calculated as;

Y = C+I+G

Y = (25 + 0.75∗ (Y−T)) + I + G

Y = ( 25 + 0.75∗ (Y−20)) + 60 + 130

Y = 25 + 0.75Y - 15 + 190

0.25Y = 200

Y = 200/0.25

Y = $800 billion

2. Government spending reduces by $100 billion.

= 130 - 100

=30

Y = (25 + 0.75∗ (Y−T)) + I + G

Y = ( 25 + 0.75∗ (Y−20)) + 60 + 30

Y = 25 + 0.75Y - 15 + 90

0.25Y = 100

Y = 100/0.25

Y = $400 Billion

3. Multiplier =
`(Increase in GDP)/(Increase in Government Spending)`

=
`(800 - 400)/(130 - 30)`

= 4