Consider a small economy that is closed to trade, so its net exports are equal t
ID: 1211153 • Letter: C
Question
Consider a small economy that is closed to trade, so its net exports are equal to zero. Suppose that the economy has the following consumption function, where C is consumption, Y is real GDP, I is investment, G is government purchases, and T stands for net taxes:
C = 40 + 0.5 * (y - t)
Suppose G = $115 billion, I = $50 billion, and T = $10 billion.
Suppose the government purchases are increased by $100 billion. The new equilibrium level of output will be equal to _____
Based on the effect of the change in government purchases on equilibrium output, you can tell that this economy's spending multiplier is equal to ____
Explanation / Answer
(1) In equilibrium, Y = C + I + G
Y = 40 + 0.5(Y - 10) + 50 + 115
Y = 205 + 0.5Y - 5
0.5Y = 200
Y = $400 billion
(2) When G increases by 100, new level of G = 115 + 100 = 215
Y = 40 + 0.5(Y - 10) + 50 + 215
Y = 305 + 0.5Y - 5
0.5Y = 300
Y = $600 billion
(3) Spending multiplier = Increase in Y / Increase in G = $(600 - 400) Billion / $100 billion = 200/100 = 2