Question

[In all cases in which you are asked to illustrate with a graph, be sure to draw it carefully and clearly label all curves and axes.]

1. C = 160 + .6YD = 160 + .6(Y – T)

I = 150

G = 150

T = 100

a) Solve for (in order): Y, YD, and C. Show your work. Calculate Z and confirm that Z = Y.

b) Draw the goods market equilibrium that corresponds to this solution. Carefully label everything in your graph including the numerical value of the y intercept.

c) Suppose that G increases to 200. What happens to Y? Calculate and illustrate on your graph.

d) Suppose that the increase in G is financed by selling bonds. Explain why the increase in Y from part c is almost surely an overstatement of the effect on Y. (Think: What is going on in the bond market?)

Answer 1

a)Y = c+ i +g

Y= 160 +0.6(Y-T) +150 +150

Y = 160 +0.6(Y -100) +300

0.4Y= 400

Y = 1000

yd = y-t = 1000 - 100 = 900

c = 160 +0.6 (900) = 700

b)

C) now g = 200

Y =

Y= 160 +0.6(Y-T) +150 +200

Y = 160 +0.6(Y -100) +350

0.4Y = 450

Y=1125

Y increases.

d) In bond market , due to increased govt expenditure , people will buy bonds due to increased interest rate , which will crowd out private investment and THUS y is overstated in part c.