Question

In the classical model, a closed economy can be described by the following equations:

C =560 + 0.6 (Y – T)

Assume that equilibrium GDP (Y) is 5500 and government spending (G) is 600, when taxes increase from 800 to 1000, the equilibrium investment will by .

Answer 1

To find the equilibrium for a closed economy with the given parameters, we calculate consumption, investment, and government spending and add them together. To align GDP with potential GDP, adjust government spending accordingly, either through direct calculation or by using the multiplier method.

Step-by-step explanation:

In a closed economy, the equilibrium GDP (Y) can be found when total production, or GDP, is equal to the aggregate expenditures on goods and services. The equilibrium condition is represented by the equation Y = C + I + G, where C is consumption, I is investment, and G is government spending. To find the equilibrium for this particular economy using the given equations, we can set up the national income accounting identity as follows:

Y = C + I + G + X - M

With no information on exports (X) and imports (M), we can simplify this to:

Y = C + I + G

Given T = 0.25Y, C = 400 + 0.85(Y - T), I = 300, and G = 200, we plug these into the equation to find Y. We calculate the taxes, T, and subtract it from Y to find disposable income, and then apply the marginal propensity to consume (0.85) to find consumption. Adding consumption, investment, and government spending together should give us Y, the equilibrium GDP.

If potential GDP is 3,500, we would adjust G to achieve this level. To find the required change in G:

1. Substitute Y = 3,500 into the equations and solve for G.
2. Alternatively, calculate the multiplier, which in this case would be 1/(1 - MPC) where MPC stands for marginal propensity to consume, and use it to determine the change in G needed to reach the potential GDP.