Question

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9. Suppose that consumption and planned investment are given respectively by C = 1000+0.65Y & Iplanned = 500+0.15Y (a) Find the equilibrium level of output in this economy. 5 points. (b) Sketch and fully label the Keynesian cross diagram for this economy. 5 points. (c) Suppose that consumers decrease their mpe by 0.35 due to uncertain times. What is the change in the equilibrium income? 5 points.

Answer 1

Solution:

a) At equilibrium, aggregate expenditure = consumption + planned investment

AE = 1000 + 0.65Y + 500 + 0.15Y

AE = 1500 + 0.80Y

At equilibrium, aggregate expenditure equals income, so

Y = 1500 + 0.80Y

Y = 1500/(1 - 0.80) = $7,500

b) For the required graph, we mark real income or GDP on horizontal axis and aggregate expenditure on vertical axis. We can draw a 45 degree line, which marks for all levels where aggregate expenditure equals real income. The point where the aggregate expenditure curve intersects the 45 degree line is the required equilibrium level.

c) With change in marginal propensity to consume, mpc, by -0.35, so new mpc = 0.65 - 0.35 = 0.30

So, new consumption function, C = 1000 + 0.30*Y

Then, new AE = (1000 + 0.30Y) + (500 + 0.15Y)

New AE = 1500 + 0.45Y

Then, new equilibrium level of output can be found as:

Y = 1500 + 0.45Y

Y = 1500/(1 - 0.45) = 2727.273

Change in equilibrium income = 2727.273 - 7500 = $4,772.727