Question

The economy is described by the following functions:

C = 100 + 0.8Y D

T x = 10

T r = 40

I = 60 + 0.1Y

G = 80

Nx = 20

Notice that in this example investment is pro-cyclical.

Q1. Write down the definition of aggregate demand, and a condition that describes equilibrium in the Keynesian Cross diagram

Q2. Substitute all the information that you were given and find equilibrium output. Illustrate on the Keynesian Cross diagram.

Q3. Illustrate equilibrium output on the Keynesian Cross diagram

Q4. Find the multiplier associated with government purchases.

Q5. Compare the multiplier that you just obtained with the one you found in class, on slide 10 (‘Keynesian Cross’ lecture). Which one is higher? Why? (explain intuitively).

Q6. Suppose government purchases increase by 30. By how much would the equilibrium output increase?

Q7. Illustrate change in government purchases on the Keynesian Cross diagram. Q8. Suppose investment increases by 10. By how much would the equilibrium output increase?

Q9. Suppose transfers increase by 30. By how much would the equilibrium output increase?

Answer 1

1. Aggregate demand is the total demand for final goods and services the economy at any given time t. The equilibrium in an economy is achieved when the aggregate demand is equal to aggregate supply. Aggregate Supply is the total amount of goods and services that are produced in the economy during the same time period t. For equilibrium the AD=AS according to Keynesian cross model.

2.

Given, C = 100 + 0.8Y D where YD = Y - Tx + Tr;  I = 60 + 0.1Y; G = 80; Nx = 20

Subsitutating each value in AD/Y equation we get:

Y = 100 + 0.8(Y - 10 + 40) + 60 +0.1Y + 80 + 20

= 100 + 0.8Y +24 + 60 +0.1Y + 100

Y - 0.8Y - 0.1Y = 284

0.1Y = 284

Y = $ 2840

3.

4. The government multiplier = dY/dG = 1/(1-MPC) = 1/0.2 = 5