The aggregate economy is given by:
C= C_0 + MPC(Y-T)
C_0=100, MPC=0.8
I=200
G=G_0-g*Y
G_0=500, g=0.2
T=500
Assume interest rates are fixed and the economy is closed (no trade with other countries). This economy is different from the basic economic model considered in class because government expenditures are determined differently.
a) How much are Aggregate Expenditures as a function of output Y?
b) How much will equilibrium output be in this economy?
c) What is the multiplier on changes in investment in this economy?
d) If investment spending rises by 10, how much will equilibrium output change?
e) A senator, wanting to stimulate the economy, proposes an increase in government spending on fine arts (which counts as G). The extra spending on the fine arts will spill over the rest of the economy as musicians and painters go out to spend and support other businesses. The Senator reports an estimate that the marginal propensity to consume is 0.8 so the multiplier is 5. In this estimate, the senator did not take into account g. Is the estimate of the multiplier too high or too low?
f) Another senator says that the government should increase spending in defense (which counts as part of
G) The senator claims that the economy will be stimulated and therefore overall government (G-gY)) spending will fall. Is the analysis correct?