Northeastern University

University College

Economic Principles I

ECN 4115, Summer 1994

Homework # 4

1. Explain graphically the determination of the equilibrium GDP by al a. The aggregate expenditures-domestic output approach and b the leakage's-injections approach for the private sector of a closed economy. Why must these two approaches always yield the same equilibrium GDP ? Explain why the intersection of the aggregate expenditure's schedule and the 45 degree line determines the equilibrium GDP ?

2. Assuming the level of investment is 16 billion and independent of the level of total output, complete the following table and determine the equilibrium level of output and income which the private sector of this closed economy would provide.

Possible levels of employment, millions	Real Domestic output (GDP=DI), billions	Consumption, Billions	Saving, billions
40	$240	$244	$--------------
45	260	260	---------------
50	280	276	------------------
55	300	292	-----------------
60	320	308	--------------
65	340	324	---------------
70	360	340	------------------
75	380	356	-----------------
80	400	372	-------------

a. If the economy has a labor force of 70 million, will there exist an inflationary or recessionary gap ? Explain the consequences of this gap.

b. Will an inflationary or recessionary gap exist if the available labor force is only 55 million ? Trace the consequences.

c. What are the sizes of MPC and MPS ?

d. Use the multiplier concept to explain the increase in the equilibrium GDP which will occur as the result of an increase in planned investment spending from $16 to $20 billion.

3. Assume the consumption schedule for the economy is such that C = 50 + 0.8Y. Assume further that the investment and net exports are autonomous.(indicated by I_go and x_no); that is, planned investment and net exports are independent of the level of income and in the amount Ig = Igo = 30 and Xn = Xno = 10. Recall also that in equilibrium the amount of domestic output produced (Y) is equal to the aggregate expenditures (C + Ig + Xn), or Y = C + Ig + Xn.

a. Calculate the equilibrium level of income for this economy. Check your work by putting the consumption, investment, and net export schedules in tabular form and determining the equilibrium income.

b. What will happen to equilibrium Y if Ig = Igo = 10 ? What does this tell you about the size of the multiplier ?

4. Use data of question 2. Assume that investment is 16 billion. Incorporate government into the table by assuming that it plans to tax and spend $20 billion at each possible level of GDP. Further assume that net exports are zero, all taxes are personal taxes, and that government spending does not induce shifts in the consumption and investment schedules. Explain the changes in the equilibrium GDP due to addition of the government sector.

5. Briefly state and evaluate the major problems encountered in enacting and applying fiscal policy. Explain the notion of a political business cycle. What is the crowding-out effect and why is it relevant to fiscal policy ? In what respect is the net export effect similar to the crowding-out effect ? How would an anticipated higher tax in the future affect the saving decisions of individuals ?