INCOME AND SPENDING EQUILIBRIUM: a) Assume that GDP (Y) is 16,000. Consumption (
ID: 1102077 • Letter: I
Question
INCOME AND SPENDING EQUILIBRIUM:
a) Assume that GDP (Y) is 16,000. Consumption (C) is given by the equation C = 1000 + 0.75(Y T). Investment (I) is given by the equation I = 8,000 500r, where r is the real rate of interest in percent. Taxes (T) are 4000 and government purchases (G) is 1000. i) What are the equilibrium values of r, C, and I? ii) What are the values of private saving, public saving, and national saving? iii) If government purchases increase to 2,000, what will be the new equilibrium values of r, C, and I? iv) What are the new equilibrium values of private saving, public saving, and national saving? (b) Using the values from question (a) iii) above, suppose that the government increases taxes and government purchases by equal amounts of 2000 (i.e., T goes from 4,000 to 6,000 and G goes from 2,000 to 4000). i) Calculate r and draw a graph with the interest rate on the y-axis and saving and investment on the x-axis demonstrating any shifts or changes in equilibrium. ii) Explain in words why there was a change in equilibrium or why there was no change in equilibrium as result of the simultaneous change in taxes and government purchases.
Explanation / Answer
a) Y = 16000 , C = 1000 + 0.75(Y - T) , I = 8000 - 500(r) , T = 4000 , G = 1000 ,
1) At equilibrium , Y = C + I + G
=> 16000 = 1000 +(0.75)*(16000 - 4000 ) +(8000 - 500*r) + 1000
=> 500*r = 3000 ;
r = 6 (%) ;
I = S ; hence
S= 8000 - ( 500*6%) = 5000
C = 1000+(0.75)*(12000) = 10000 ; private saving = 12000 - 10000 = 2000
3) if G increases to 2000 , then using same method as above , r = 8 ( % ) ; I = 4000 , C = 10000
4)S = 4000 , private saving = 2000, public saving = 2000
b) if T and G rises by 2000 ,
using above same method to compute r
r = 9 (%)
graph will be -vely sloped line in 1st quadrant .
A simultaneous change in G and T changes the Y ( GDP) and hence Investment component of Y , hence r is effected