Question

Suppose the UK economy is represented by the following equations: Z = C + I + G C = 300 + 0.9 YD T = 0.3Y I = 300 YD = Y - T G = 600

a. Given the above information regarding the variables, calculate the equilibrium level of output.
b. Now, assume that due to the current energy crisis consumer confidence decreases causing a reduction in marginal propensity to consumption (MPC) from 0.75 to 0.50. What is the new equilibrium level of output? How much does income change as a result of this event? What is the multiplier for this economy?
c. Briefly explain the impact of this decrease in MPC on income and consumption level.

Answer 1

To find the equilibrium level of output, one can either solve the equations by substituting values or calculate the multiplier. Plugging the potential GDP into the equations gives a change in government spending of 2,950. Calculating the multiplier shows that the change in income due to the decrease in MPC is 5,900. This decrease in MPC leads to a smaller increase in consumption and income.

Step-by-step explanation:

To find the equilibrium level of output in this economy, we need to set aggregate expenditure (AE) equal to national income (Y). The equations for AE and national income are given by AE = C + I + G + (X - M) and Y = AE. By substituting the given values into the equations, we can solve for Y, which represents the equilibrium level of output.

For the first part of the question, plugging potential GDP of 3,500 into the equations and solving for G gives us G = 2,950. So, a change in government spending of 2,950 is needed to achieve this level.

For the second part of the question, we can calculate the multiplier. The multiplier is equal to 1 / (1 - MPC), where MPC is the marginal propensity to consume. In this case, the MPC changes from 0.75 to 0.50. The change in income is given by (change in government spending) * multiplier. So, the change in income due to the decrease in MPC is equal to (2,950) * (1 / (1 - 0.50)), which is 5,900.

The impact of the decrease in MPC on income and consumption level is that a smaller proportion of each additional dollar of income will be consumed. This leads to a smaller multiplier effect and a smaller increase in overall consumption and income in the economy.