Question #2 (5 Marks) Assume equilibrium GDP is $800 billion and MPE is 0.75 and

Question

Question #2 (5 Marks) Assume equilibrium GDP is $800 billion and MPE is 0.75 and is the only leakage. Spending = Income TPE) AE C+1+G 0. 800 GDP per Year (S billions) (a) If government expenditures increase by $5 billion, by how much will the total planned expenditure TPE(AE) curve shift? Will it shift upward or downward? What would be the new equilibrium GDP? If taxes increase by $2 billion, by how much will the total planned expenditure curve shift equilibrium GDP? (b) ? Will it shift upward or downward? What would be the new

Explanation / Answer

Question 2

(a)

Government expenditure is a component of the total planned expenditure TPE (AE).

So, if government expenditure increases by $5 billion, the total planned expenditure TPE (AE) curve will shift by $5 billion.

Increase in government expenditure shifts AE curve upward.

So, the total planned expenditure TPE (AE) curve will shift upward.

Calculate the Multiplier -

Multiplier = 1/(1-MPE) = 1/(1-0.75) = 1/0.25 = 4

Calculate the new equilibrium GDP =

New equilibrium GDP = Initial equilibrium GDP + Increase in GDP

New equilibrium GDP = $800 billion + ($5 billion * 4) = $800 billion + $20 billion = $820 billion

So,

The new equilibrium GDP would be $820 billion.

(b)

Increase in taxes by $2 billion will decrease the income by $2 billion. This will lead to decrease in consumption expenditure.

Decrease in consumtption expenditure = Decrease in income * MPE = $2 billion * 0.75 = $1.5 billion

Consumption expenditure is a component of the total planned expenditure TPE (AE).

So,

If taxes increases by $2 billion, the total planned expenditure curve will shift by $1.5 billion.

Decrease in consumption expenditure shifts the AE curve downward.

So,

The total planned expenditure TPE (AE) curve will shift downwards.

Calculate the Multiplier -

Multiplier = 1/(1-MPE) = 1/(1-0.75) = 1/0.25 = 4

Calculate the new equilibrium GDP =

New equilibrium GDP = Initial equilibrium GDP - decrease in GDP

New equilibrium GDP = $800 billion + ($1.5 billion * 4) = $800 billion - $6 billion = $794 billion

So,

The new equilibrium GDP would be $794 billion.

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