Consider a small country that is closed to trade, so its net exports are equal t
ID: 1212620 • Letter: C
Question
Consider a small country that is closed to trade, so its net exports are equal to zero. The following equations describe the economy of this country in billions of dollars, where C is consumption, DI is disposable income, I is investment, and G is government purchases:
C = 30 + 0.8 x DI
G = 50
I = 60
Initially, this economy had a lump sum tax. Suppose net taxes were $50 billion, so that disposable income was equal to Y – 50, where Y is real GDP. In this case, this economy's aggregate output demanded was ________
.
Suppose the government decides to increase spending by $10 billion without raising taxes. Because the spending multiplier is ________ , this will increase the economy's aggregate output demanded by ________
.
Now suppose that the government switches to a proportional tax on income of 10%. Because consumers retain the remaining 90% of their income, disposable income is now equal to 0.90Y. In this case, the economy's aggregate output demanded is _________
Under a proportional tax on income of 10%, the spending multiplier is approximately _______ . Therefore, if the government decided to increase spending by $10 billion without raising tax rates, this would increase the economy's aggregate output demanded by approximately _______ .
A $10 billion increase in government purchases will have a larger effect on output under a ____ .
Explanation / Answer
1. Y = C + I + G = 30 + 0.8(Y - 50) + 50 + 60
Y - 0.8Y = 100
Y = 100/0.2 = 500
2. Spending Multiplier = 1/1-mpc = 1/1-0.8 = 5
3 5*$10 Billion = $50 billion
4. Y or Aggegrate output = 140 + 0.8* 0.9Y
Y - 0.72Y = 140
Y = 140/0.28 = 500
5 Spendiing Multiplier = -mpc/1-mpc = -0.8/1-0.8 = -0.8/0.2 = -4
6. 4*10 = 40 billion
7. lumsum case.
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