Question

. Suppose an economy is represented by the following equations.

Consumption function                                      C = 200 + 0.8Yd

Planned investment                                                         I = 400

Government spending                                                   G = 600

Exports                                                                      EX = 200

Imports                                                                   IM = 0.1Yd

Autonomous Taxes                                                       T = 500

Marginal Tax Rate                                                               t=0.2

Planned aggregate expenditure         AE = C + I + G + (EX - IM)

By using the above information calculate the equilibrium level of income for this economy and explain why fiscal policy becomes less effective in an open economy

Answer 1

C = Consumption function

I = Investment

G = Government spending

NX = Export - Import

Yd = Y - T

The equilibrium is given by:

Y = AE

Y = C + I + G + NX

Y = 200 + 0.8(Y-500) + 400+ 600 + 200 - 0.1(Y-500)

Y = 200 + 0.8Y - 400 + 400 + 800 - 0.1Y + 50

Y = 1050 + 0.7Y

0.3Y = 1050

Y = 3500

Hence, the equilibrium level of income is Y = 3500

It shall be noted that fiscal policy becomes less effective in an open economy because, with the increase in the income circulation in the economy with the adoption of expansionary fiscal policy, there occurs a leakage in the form of increasing imports with the increasing level of disposable income. As the imports increase with the increase in disposable income, that portion of income used to buy increased imports would not be a part of aggregate spending on the domestic goods & services.