Equilibrium output in a closed economy is £1, 000. The marginal propensity to consume out of disposable income is 0.8, the net tax rate is 0.25 and investment is £80. Autonomous consumption is £200.

Question

Investment rises by £50. What are the new equilibrium levels of C, Y , I, and G? What is the effect on the budget deficit?

Answer 1

I. In a closed Economy the equilibrium income = Y= C + I + G The above is the Keynesian model formula for equilibrium income Let C represent the consumption function. Y represent national income and Trepresent taxes. At equilibrium level of Y AS = AD Y = C + I + (Y-T) In equilibrium total spending matches total income or total output. When MPC is 0.8 The multiplier (k) 1/(1-MPC) = 1/ 1-0.8 = 1/0.2 =5 Solution Step 1 Y = 200 + 0.8(Y - 0.25Y) + 80 The consumption function = C = 200 + 0.8(Yd). Solution Calculate new equilibrium output Step 1 Solve the equation for Y Step 2 Insert the term 0.25Y for the tax rate Step 3 Work through the algebra and solve for Y