Some problems and its solutions for a revision

1. Assume the following model of the economy:

C = 180 + 0.8(Y-T)
I = 190
G = 250
T = 150
a. What is the value of the MPC in this model?
b. Draw the planned expenditure curve and indicate its slope and y-intercept.
c. Compute the equilibrium level of income, that is, the level of income that
equates planned (E) and actual (Y) expenditure.
d. Calculate the level of unplanned inventory accumulation when Y = 3000.

The solution

a. The value of the MPC in this model is 0.8

b. The planned expenditure curve is showed bellow :
 c. In order to compute the equilibrium level of income we
have to apply the following equilibrium condition:
AS=AD
Or
Actual expenditure = Planed expenditure
Y= C + I + G
Y = 180 + 0.8(Y-150) + 190 + 250
Y= 500 + 0.8Y
0.2Y=500
Y= 500/0.2 = 2,500
d. The level of unplanned inventory accumulation when Y =
3000 can be calculated as follows:
Y2-Y1 = 3000 – 2500 = 500

2. Consider the same model as in Problem 1:

a. Compute the initial equilibrium level of income.
b. If government purchases were to increase by 10 to 260, what
would happen to each of the following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
c. Starting again at G = 250, suppose that taxes increased by 10 to
160. What would happen to each of the following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
d. Starting over one last time at G = 250 and T = 150, suppose that
government expenditures and taxes were both increased by 10 to
260 and 160, respectively. What would happen to each of the
following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
The solution

a. In order to compute the initial equilibrium level of income we have

to apply the following equilibrium condition:
AS=AD
Or
Actual expenditure = Planed expenditure
Y= C + I + G
Y = 180 + 0.8(Y-150) + 190 + 260
Y= 510 + 0.8Y
0.2Y=510
Y= 510/0.2 = 2,550
b. This is what would happen to the planned expenditure
curve:
When an increase in government purchases raises income, it also raises
consumption, which further raises income, which further raises consumption, and
so on. Therefore, in this model, an increase in government purchases causes a
greater increase in income.

The equilibrium level of consumption at y= 2500 is:

C = 180 + 0.8(Y-T)
C = 180 + 0.8(2500-150) = 2060
The new equilibrium level of consumption when ∆G = 10 is:
C = 180 + 0.8(Y-T)
C = 180 + 0.8(2550-150) = 2100
The government budget deficit is
T – G =150 – 260 = - 110
c. In order to compute the equilibrium level of income when tax
increases from 150 to 160 , we have to apply the following
equilibrium condition:
AS=AD
Y= C + I + G
Y = 180 + 0.8(Y-160) + 190 + 250
Y= 492 + 0.8Y
0.2Y=492
Y= 492/0.2 = 2460
The new equilibrium level of consumption is:
C = 180 + 0.8(Y-T)
C = 180 + 0.8(2460-160) = 2020
Test yourself by answering choice d?
3. In the economy of St. Maynard Island, autonomous consumption
expenditure is $185 million, and the marginal propensity to consume is
0.75. Investment is $150 million, government expenditure is $100 million,
and net taxes are $80 million. Investment, government expenditure, and
taxes are constant they do not vary with income. The island does not trade
with the rest of the world.
a. Draw the aggregate expenditure curve.
b. What is the islandʹs autonomous consumption?
c. What is the size of the multiplier in St. Maynard Islandʹs economy?
d. What is the islandʹs aggregate planned expenditure and what is happening
to inventories when real GDP is $1,100 million?
e. What is the economyʹs equilibrium aggregate expenditure?

The solution
a. Draw the aggregate expenditure curve.
See the figure above. Because the island does not trade with the rest of the world,
net exports are zero. When net exports are zero, aggregate expenditure, or AE, is
given by AE = C + I + G. Consumption equals $185 million plus 0.75 of
disposable income, so the consumption function is C = $185 million + 0.75(Y - T),
where $185 million is autonomous consumption, 0.75 is the marginal propensity
to consume, and Y - T is disposable income, real income minus net taxes. (Real
income also equals real GDP.)
Because net taxes are constant, the consumption function is:
C = $185 million + 0.75(Y - $80 million).
Using the formula in the equation for aggregate expenditure gives
AE = $185 million + 0.75(Y - $80 million) + $150 million + $100 million
So, aggregate expenditure is given by AE = $375 million + 0.75Y.
b. Autonomous expenditure is expenditure that does not vary
with real GDP; it is the level of aggregate expenditure if
real GDP were equal to zero. In the economy of St.
Maynard Island, if Y = 0, AE = $375 million + 0.75 (0, so
autonomous expenditure is $375 million, which is point A
in the figure above.
c. The multiplier is the amount by which a change in
autonomous expenditure is multiplied to determine the
change in equilibrium expenditure and real GDP. The
multiplier equals 1/(1 - slope of AE curve). The slope of the
AE curve is 0.75, so in the economy of St. Maynard Island,
the multiplier is 1/(1 - 0.75) = 4.
d. When real GDP is $1,100 million, aggregate planned
expenditure, AE, equals $375 million + 0.75 × $1,100
million, which is $1,200 million. This level of aggregate
planned expenditure is point B in the figure above. Because
this level of aggregate planned expenditures exceeds real
GDP, point C in the figure, inventories decrease.
e. Equilibrium expenditure is the level of aggregate
expenditure that occurs when aggregate planned
expenditure, AE, equals real GDP. In the economy of St.
Maynard Island equilibrium is at point E in the figure,
when real GDP and aggregate expenditure equal $1,500
million. Equilibrium expenditure also can be calculated by
solving the equation Y = $375 million + 0.75Y for Y. Start
by subtracting 0.75Y from both sides to give 0.25Y = $375
million. Then divide both sides by 0.25 to obtain Y = $375
million/0.25, so that Y, which is real GDP, equals $1,500
million.