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Hypothetical Economy with Fixed Price Level and Interest Rates

Assume the following equations (in billions of dollars) describe a hypothetical economy where both the price level and interest rates are fixed.

C=110 + 0.75(YD)
YD= Y - NT
NT = 0.2Y
I = 175
G = 80
EX = 70
IM = 30 + 0.1Y

*NOTE: NT means net taxes. YD means disposable income.

i) What is the equilibrium level of income (real GDP) in this economy?

ii) Calculate the autonomous expenditure multiplier for this economy

iii) Graph the aggregate expenditure function to show autonomous aggregate expenditure, the slope of the aggregate expenditure function and equilibrium income

iv) What changes in government spending would be necessary to move the present equilibrium GDP (calculated for part (i) above) to the full employment level of 1000

v) What changes in transfer payments would be necessary to move the economy towards full employment GDP of 1000.

Solution Preview

i) Equilibrium level of income must be computed as
<br>
<br>Y= C + I + G + EX - IM
<br>Y= 110 + 0.75(Y- 0.2Y) + 175 + 80 + 70 - 30 - 0.1Y
<br>Y - .75Y + .15Y + .1Y = 110 + 175 + 80 + 70 - 30
<br>Y ( 1-.75 +.15 + .1) = 405
<br>Y= 405*(1/0.5)
<br>Y = 810
<br>
<br>ii) The autonomous expenditure multiplier is given by (1/0.5) = 2. Thus, each time autonomous ...

Solution Summary

Describe a hypothetical economy where both the price level and interest rates are fixed.

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