Question

1) The GDP determination model has been modified, it now requires households to pay a proportional tax to the federal government. Use the data below to answer the questions. a = 5000, b = .95 yf = 195,000 G = 32000 IP = 20000 T = .20Y a) Find the current equilibrium for the economy. Describe the current state of the economy. Discuss the following attributes: unemployment, inflation and growth in RDGP. Show work.

Answer 1

A. According to IS equation, Aggregate demand is sum of consumption expenditure, investment expenditure and government expenditure.

Y= C+I+G

Where, C= a+bYd and Yd = Y-T

Thus, Y= C+I+G=>Y= 5000+0.95(Y-0.20Y)+20000+32000

=> Y= 57,000+ 0.95(0.80Y) => Y= 57,000 + 0.76Y

=> Y-0.76Y= 57000 => 0.24Y= 57000 => Y= 237,500

Thus, currently the output of economy is 237,500.

The potential output of economy, Yf is 195,000.

There is an imbalance between potential output and actual output and thus an output gap.

The output gap = Y-Yf = 237,500-195,000 = 42,500

Since the output gap is positive, the economy is going through an economic boom period.

During positive output gap, the economy has more aggregate demand than it can sustainably produce. Under such a condition, the firms (due to huge demand) will ask workers to work overtime and pay higher wages. Thus, unemployment will be low or no unemployment will be there/ resources will be optimally or overused.

Because the demand is much higher than what can be produced by the economy, the price level will increase. Thus, there will be inflationary pressure in the economy.

Real gdp will return to potential GDP after the economy adjusts to the short run effect that spurs the Aggregate demand. The real gdp will start to fall until it reaches potential GDP.