Question

ONLY 5-11 BELOW

A5-10. Suppose the following aggregate expenditure model describes an economy:
C = 100 + (5/6)Yd T = (1/5)Y I = 200 G = 400 X = 300 IM = (1/3)Y

where C is consumption, Yd is disposable income, T is taxes, Y is national income, I is investment, G is government spending, X is exports, and IM is imports.

1. (a) Derive a numerical expression for aggregate expenditure (AE) as a function of Y. Calculate the equilibrium level of national income. Illustrate in a diagram with AE on the vertical and Y on the horizontal axis. [Hint: While solving, do not convert the fractions to decimals.] [6]

2. (b) Calculate the equilibrium levels of disposable income, consumption spending and private saving (S). Is the government running a surplus or deficit? Does the country have a trade surplus or deficit? [8]

3. (c) Now imagine that as a result of international trade tensions exports decrease by 200. What is the new level of national income? Illustrate the effects of your diagram. What is the effect on the government’s budget? [Hint: Using the multiplier simplifies the calculations.] [6]

4. (d) The government decides to use an increase in government spending to restore national income to its original level. By how much would it have to increase spending? What happens to the government’s budget balance? Explain why the government’s deficit does not increase by the full amount of the increase in spending. [6]

A5-11. Suppose that the initial equilibrium in the previous question was both a short and long-run equilibrium in AD-AS space.

1. (a) Analyze the short-run effects of the event described in part (c) above. Would the effect on real GDP be the same or different? Explain. [4]

2. (b) Show the effect of the government’s action from part (d) above. How is the price level affected compared to your answer in part (a) of this question? [4]

3. (c) Suppose instead that the government did not respond as in part (d) above. How would the economy adjust? What would be the long-run level of real GDP? [4]

Answer 1

(A5-11)

(a)

A fall in exports will reduce net exports, which will decrease aggregate demand. The AD curve will shift to left, which will lower both price level and real output, thus raising unemployment.

(b)

Increase in government spending will increase aggregate demand, shifting AD curve to left until initial long-run equilibrium is achieved.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real output (= potential output) Y0.

Due to lower exports, AD0 has shifted left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1 in short run.

After increase in government spending, aggregate demand rises, shifting AD1 rightward until it reaches AD0, intersecting SRAS0 and LRAS0 at point A, restoring initial long-run equilibrium.

After government intervention by increasing spending, price level is higher compared to in part (a).

LRASO SRAS. SRAS, Y Yo

(c)

If government doesn't intervene, then lower price level (discussed in part a in this question) will reduce prices of inputs, raising production costs. Firms will increase production, increasing aggregate supply. So, SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real output to potential output.

In above graph, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real output to potential output Y0.