Question

Application: (20 points) The Expenditure-Output Model below shows a hypothetical economy in the short run. Use the information in the diagram to answer the questions that follow Aggregate Expenditures (5 billions) 210 45°-line AE =C+I+G+ NX Consumption Function 30 0 30 60 90 120 150 180 210 Real GDP ($ billions) (A) (2 points) What is the equilibrium level of Real GDP in this economy? (B) Suppose this economy initially had produced a Real GDP level of $30 billion. (a) (3 points) What will happen to unplanned inventory investment in the economy? (b) (3 points) What are firms likely to do in this situation? (C) Suppose this economy had initially produced a Real GDP level of $150 billion. (a) (3 points) What will happen to unplanned inventory investment in the economy? (b) (3 points) What are firms likely to do in this situation? (D) (3 points) What is the value of the simple expenditure multiplier in this economy? E) (3 points) Suppose this economy is currently producing the equilibrium level of output. If investment expenditures increase by $50 billion, ceteris paribus, by how much will output (real GDP) change in this economy?

Answer 1

A) Equilibrium level of real GDP is $120 billion. It is determined by the intersection of aggregate expenditure curve and 45 degree line.

B) a) Unplanned inventory investment is less than planned investment. Inventory Investment will increase.

b) Firms will increase the production and will increase its output to a level equal to equilibrium output.

C) a) When real GDP is at a level of $150 billion, actual investment is greater than the planned investment. inventory investment will fall back.

b) Firms will cut back their production and bring the output back to equilibrium level.

D) MPC is 0.5

multiplier = 1/0.5

= 2

E) If investment expenditure increases by $50 billion, output will increase by multiplier effect , that is,

= 2 * $50

= $100 billion