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the effect on the marginal propensity to spend

Question 1
Consider the following information about the demand for goods and services. All variables are in billions of dollars.

Consumption Function: C = 1000 + 0.9 YD
Investment Demand: I = 1400
Government Purchases: G = 1500
Taxes: Ta = 1000 + 0.15 Y
Transfer Payments: Tr = 1100
Exports: X = 800
Imports: Imp = 1200

a. Suppose that the potential level of output is $12,000 billion. Use the above information to calculate the size of the output gap?the actual level of output minus the potential level?if the economy is at equilibrium, that is, the actual level of output is the equilibrium level. Show your work and illustrate the size of the output gap graphically with a Keynesian cross diagram.

b. Calculate the size of the trade deficit or trade surplus at equilibrium. Be clear whether there is a deficit or a surplus.

c. Suppose that next year the economy reaches potential output, that is,
the equilibrium level of output next year is $12,000 billion. Calculate the magnitude of the exogenous change in aggregate demand that is necessary to achieve this result. Show your work.

d. Now assume that Imports also vary positively with income such that
Imp = 1200 + 0.1Y.
First, explain what will be the effect on the marginal propensity to spend, that is, on the slope of the AD curve and illustrate graphically.
Second, explain what will be the effect on the multiplier. Be clear about the form of the multiplier and why it changes.

Solution Preview

See attached.

Consider the following information about the demand for goods and services. All variables are in billions of dollars.

Consumption Function: C = 1000 + 0.9 YD
Investment Demand: I = 1400
Government Purchases: G = 1500
Taxes: Ta = 1000 + 0.15 Y
Transfer Payments: Tr = 1100
Exports: X = 800
Imports: Imp = 1200

a. Suppose that the potential level of output is $12,000 billion. Use the above information to calculate the size of the output gap—the actual level of output minus the potential level—if the economy is at equilibrium, that is, the actual level of output is the equilibrium level. Show your work and illustrate the size of the output gap graphically with a Keynesian ...

Solution Summary

The effect on the marginal propensity to spend is depicted.

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