Question

1) Suppose the Real GDP of an economy in a particular year was $ 1000 billion.

With the help of a circular flow diagram (you need not show on your answer) please show that the Aggregate Expenditure equals to the Aggregate Income of the economy for the year with the following information: Government took 25% of the income as tax; Consumption for that year was 60% of the disposable income; all the savings were invested as investments; government transferred 10% of tax revenue to households as transfer payments and spent the rest as government purchases and the net export is zero.

Answer 1

GDP (Income approach) = $1000 Billion = Total factor payments or income............... (i)

GDP (Expenditure approach) = Y = Consumption (C) + Investments (I) + Government Expenditure (G) + Net Exports (NE)

Effective tax rate = 25% - 10%(transfer payments to households) = 15%

G = Tax (T) =1000 X 0.15 = $150 Billion

C = 0.60 X (1000 - T ) = $ 510 Billion

I = Savings (S) = 0.40 X (1000 - T ) = $ 340 Billion

Therefore, Y = 510 + 340 +150 +0 = $1000 Billion........................(ii)

Since (i) and (ii) as above are equal, hence the aggregate expenditure equals to the aggregate income.