Imagine an economy in which consumer expenditure is represented by the following
ID: 2495914 • Letter: I
Question
Imagine an economy in which consumer expenditure is represented by the following equation:
C=50+.75DI
Imagine also that investors want to spend 500$ at every level of income (I=500$), net exports are zero (X-IM=0), government purchases are 300$, and taxes are 200$
A. What is the Equilibrium price at GDP
B. If potential GDP is 3000, is there a recessionary or inflationary gap? if so, how much?
C. What will happen to the equilibrium level of GDP if investors become optimistic about the countrys future and raise their investment to 600$.
D. After investment has increased to 600$, is there a recessionary or inflationary gap? How Much?
Explanation / Answer
(A) In equilibrium,
Y = C + I + G + NX = 50 + 0.75 x DI + 500 + 300 + 0
Y = 0.75 x (Y - T) + 850
Y = 0.75 x (Y - 200) + 850
Y = 0.75Y - 150 + 850
0.25Y = 700
Y = 2800
(B) There is a recessionary gap because actual GDP (Y) is less than potential GDP.
Gap = Potential Y - Actual Y = 3000 - 2800 = 200
(C) If I increases to 600 (an increase of 100):
Y = 0.75Y - 150 + 850 + 100
0.25Y = 800
Y = 3200
Equilibrium GDP increases by (3200 - 2800) = 200
(D) Now, there is an inflationary gap because Actual GDP is more than potential GDP.
Gap = Actual GDP - Potential GDP = 3200 - 2800 = 400