Question

The total expenditure schedule in Macroland begins with these initial levels (in billions of dollars): Income = 1,000; Consumption = 900; Investment = 200; Government = 300; Net Exports = −100. If the MPC = 0.75 and income increases in increments of 200, find the equilibrium level of income. If full employment requires an income level of 2,000, what (if anything) should the government do? Indicate both the direction of the spending change and the size of the spending change.

Answer 1

Equilibrium occurs when Y + C + I + G + NX

where Y = income, C = Consumption = 900, I = Investment = 200; G = Government spending = 300; NX = Net Exports = −100

=> Y = 900 + 200 + 300 + (-100) = 1300

Hence, Current Income = 1300 and full employment income = 2000. So government has to increase overall income by 2000 - 1300 = 700

Here MPC = 0.75 => Multiplier = 1/(1 - MPC) = 1/(1 - 0.75) = 4

This means that $1 increase in autonomous spending(like government spending) would increase income by $4. So In order to increase income by 700, Government spending should increase by 700/4 = 175

Hence, Government Spending should increase by 175