Consider a small economy that is closed to trade, so its net exports are equal t
ID: 1213260 • 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 is for net taxes:
Suppose G = $25 billion, I = $60 billion, and T = $20 billion.
Suppose the government purchases are increased by $50 billion. The new equilibrium level of output will be equal to $__________ billion.
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
(a)
Y = 30 + 0.75(Y - T) + 60 + 25
Y = 115 + 0.75(Y - 20)
Y = 115 + 0.75Y - 15
0.25Y = 100
Y = 400
(b) G rises by $50 billion.
So,
Y = 115 + 0.75(Y - 20) + 50 = 165 + 0.75(Y - 20)
Y = 165 + 0.75Y - 15
0.25Y = 150
Y = 600
(c)
Increase in Y due to increase in G = $(600 - 400) billion = $200 billion
So, Spending multiplier = Increase in Y / Increase in G = $200 billion / $50 billion = 4