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