Question

Part I. Answer in the space below. 1. (12 marks) This is a question about the Keynesian cross diagram. Suppose that planned aggregate expenditure (PAE) is given by the equation: PAE-2000+ 0.5 (Y). You also know that actual output is 4,000 and potential output is 3,600. a. Label the axes of figure below. b. Add the PAE and Y-PAE lines. Label the lines and the vertical intercept. c. Show actual output and potential output on the horizontal axis. Represent potential output with a vertical line. d. Indicate the output gap and state the type of output gap it is. e. Calculate how much you would have to increase/decrease autonomous expenditures? te

Answer 1

a) For the Keynesian cross diagram , the Y-axis is measured as PAE - Planned Aggregate Expenditure and X-axis is measured as Real Output (Y)

b) The PAE and Y=PAE line is shown to be added in the graph. These lines has been labeled.

For PAE expression, the vertical intercept is 2000, which is the value of PAE when Y=0

c) The actual output and potential output are measured along X-axis. The Potential Output is shown be vertical line at 3600 mark

For a), b) and c), refer the diagram given below:

Y	PAE = 2000 +0.5Y	Y=PAE	Potential Output
0	2000	0	3600
400	2200	400	3600
800	2400	800	3600
1200	2600	1200	3600
1600	2800	1600	3600
2000	3000	2000	3600
2400	3200	2400	3600
2800	3400	2800	3600
3200	3600	3200	3600
3600	3800	3600	3600
4000	4000	4000	3600
4400	4200	4400	3600
4800	4400	4800	3600
5200	4600	5200	3600
5600	4800	5600	3600

d) The output gap refers to the difference between actual output and potential output.

Since, the actual equilibrium output is 4000 and potential output is 3600, the output gap is: 4000-3600 = 400

Since, the output gap is positive, it is inflationary gap

e) Since, the marginal propensity to consume - slope of the PAE equation is 0.5

The multiplier is (1/(1-0.5))=2

To close the output gap such that output level in the economy corresponds to potential output level, the autonomous expenditure should decrease by:

400/multiplier

=400/2

= 200

Thus, autonomous expenditure should decrease by 200 such that equilibrium level of output is potential output level.