Question

Consider a closed economy to which the Keynesian-cross analysis applies. Consumption is given by the equation C = 200 + MPC(Y – T). Planned investment (I) is 300, government spending (G) is 300 and taxes (T) is 300. Assume MPC is equal to 2/3.

(a) If Y is 1,500, what is planned spending? What is inventory accumulation or decumulation? Is equilibrium Y higher or lower than 1,500?

(b) What is equilibrium Y?

*(1 mark)*

(c) What are equilibrium consumption, private saving, public saving, and national saving?

(d) How much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending?

Answer #1

C = 200 + MPC * '(Y - T)

I = 300

G = 300

T = 300

MPC = 0.67

**a)** If Y = 1,500

Planned spending = 200 + 0.67 (1,500 - 300) + 300 + 300 = 1,600

Inventory accumulation occurs if equilibrium output is more than current spending. If Y = 1,500, there occurs inventory accumulation because equilibrium Y is 1,800.

**b)** Equilibrium Y = C + I = G

Y = 200 + 0.67 (Y - 300) + 300 + 300

Y = 200 + 0.67Y - 200 + 300 + 300

0.33Y = 600

Y = 1,800

**c)** Consumption = 200 + 0.67 * (1,800 - 300) =
1,200

Private saving = Y - T - C = 1,800 - 200 - 1,200 = 400

Public saving = T - G = 200 - 300 = -100

National saving = Private + Public saving = 400 - 100 = 300

**d)** Multiplier = [1 / (1 - MPC)]. Put value of
MPC which gives multiplier = 3

If government spending reduces by 200, aggregate demand falls by 200 * 3 = 600

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