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.

thanks youu :) (:

Answer 1

At equilibrium,

Y = AE

or, Y = C + I + G + (EX - IM)

or, Y = 200 + 0.8Yd + 400 +600 + (200 - 0.1Yd)

or, Y = 1400 + 0.7Yd

or, Y = 1400 + 0.7(Y - T)

or, Y = 1400 + 0.7(Y - 500 -0.2Y)

or, Y = 1400 + 0.7(1 - 0.2)Y - 350

or, Y = 1050 +0.56Y

or, 0.44Y = 1050

or, Y = 2386.36

Hence, the equilibrium level of income is 2386.36 unit (rounded to 2 decimal places).

Fiscal policy becomes less effective in open economy. In an open economy expansionary fiscal policy leads to increase in interest rate and appreciate the currency. So, the export demand falls. on the other hand, it increases the import demand. So, trade deficit increases. As a result aggregate demand falls. Hence, the effectiveness of expansionary fiscal policy is less for open economy.