Answer to Question #163380 in Macroeconomics for Leo Maloney

Question

A1-5. Suppose an economy is described by following aggregate expenditure (AE) model: C = 40 + 0.75YD I = 60

where C is consumption (0.75 is the marginal propensity to consume) YD is disposable income, and I is investment spending.

1. (a) Derive an expression for AE as a function of Y. Calculate the equilibrium level of Y and illustrate in a diagram with AE on the vertical and Y on the horizontal axis. [5]
2. (b) Calculate the level of consumption. Express the components of aggregate expenditure (C, and I) as percentages of GDP (to one decimal place). Derive the saving function and solve for the equilibrium level of saving. [5]
3. (c) What is the value of the multiplier in this model? [5]
4. (d) Suppose there is an investment boom that leads to an increase in investment of 25. Calculate the new level of GDP. Illustrate in your diagram. Briefly explain why the old level of national income is new longer the equilibrium level. [5]

Answer 1

1a. AE as a function of Y

AE = C+I+G

= 40+0.75Y+60

AE = 100+0.75Y

at equilibrium level Y = AE

Y = 100+0.75Y

Y at equilibrium = 400.

b. Level of consumption. C = 40+0.75Yd

C = 40+(0.75*400). 

C = 340.

% of C in GDP = (340/400)*100 = 85.0%

% of I in GDP = (60/400)*100 = 15.0%

savings function S = -C+(1-MPC)*Y

S = -40+0.25Y

S = -40+(0.25*400)

S = 60.

c. Multiplier = (1- MPC)

= 1- 0.75

= 0.25

d. New I = (60+25) =85

AE after increased I = 40+0.75Y+85

AE = 125+0.75Y 

AE = 125+(0.75*400)

AE = 425