Module 8

Q2 The 45 degree line

When you construct a 45 degree line on an X-Y coordinate plan, at any point on this line the X coordinate = Y coordinate. In the Keynesian income-expenditure model, the demand side is in equilibrium when Y = AE. (This is tricky.) Therefore the demand side is in equilibrium when the AE curve intersects the 45 degree line.

Q4 Equilibrium GDP (III)

(a) Equilibrium Y = 2000 (b) New equilibrium Y = 2100 (c) Increase in G = 40 and increase in Y = 100. Y > G due to multiplier effect.

Q8 Fiscal Balance

(a) C = 6 + 0.8(1-0.25)Y = 6 + 0.6Y

(b) AE = C + I + G + (X – M) = 30 + 0.5Y

(c) Ye = 60

(d) K = 1/(1 – MPC*) *MPC = MPC on domestic GDP = 1/(1-0.5) = 2

(f) New equilibrium GDP = 70

K = Y/G = (70 – 60)/5 = 2

(g) At Y = 70:

T = 0.25Y = 17.5

G = 10

Government budget balance = 17.5 – 15= 25 (budget surplus)

Q9 More Practice on Multiplier

(6)

(a) The consumption function is C = 1 + 0.95(Y – T ) where the “1” is 1 billion and T = 4.

(b) The equation of the AE curve is: AE = 5.2 + 0.95Y, where Y is real GDP. (See working below.)

AE = C + I + G

AE = 1 + 0.95(Y – 4) + 4 + 4

AE = 1 + 0.95Y – 3.8 + 4 + 4

AE = 5.2 + 0.95Y

(c) Equilibrium expenditure is $104 billion. (Follow the same procedure as in 3(b).)

(d) The multiplier is 20 and hence the equilibrium real expenditure decreases by $60 billion (to $44 billion).

Explanation: The multiplier equals 1/(1 the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.95. So the multiplier is 1/(1 0.95), which is 20. Then, the change in equilibrium expenditure equals the change in investment, –$3 billion, multiplied by 20.

(8) (a) The quantity demanded increases by $20 billion.

The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier. The multiplier is 20 and the change in investment is $1 billion. Thus the aggregate demand curve shifts rightward by $20 billion.

(b) In the short run, real GDP increases by less than the increase in the quantity of real GDP demanded. It is because the economy is at full employment, and so increase in AD will cause the price level to rise. The price effect will reduce the quantity of real GDP demanded. (c) In the long-run, real GDP equals potential GDP, so in the long run real GDP does not change. In the long run, the SAS curve shifts so that real GDP is determined by the intersection of the AD curve and the LAS curve. After the initial increase in investment, money wages increase and, as a result, the SAS curve shifts leftward. Eventually in the long run, real GDP moves back to equal potential GDP. (d) In the short run, the price level rises. (e) In the long run, the price level rises further.

Module 9

Q1 Policy Implications

(8) (a) The price level increases and real GDP increases. (More detailed explanation: Potential GDP is $250 billion, but actual real GDP is $200 billion. The economy is at a below full-employment equilibrium and a deflationary gap exists. If the Reserve Bank gets the rate of interest right the economy returns to full employment real GDP and cyclic unemployment is avoided.) (b) The price level falls and the fall in aggregate demand increases the deflationary gap. (More detailed explanation: Potential GDP is $250 billion, but actual real GDP is $200 billion. The economy is at a below full-employment equilibrium and a deflationary gap exists. An increase in interest rates by the Reserve Bank will decrease aggregate demand and the aggregate demand curve will shift leftward and there is a bigger gap between actual real GDP and potential real GDP; the Okun gap is larger.) (c) The Reserve Bank should lower the interest rate to reduce the deflationary gap. (More detailed explanation: Increasing the cash rate when a deflationary gap exists will increase