Problem
You are given the following model that describes the economy of Hypothetica.
(1) Consumption function: C = 100 + .8Yd
(2) Planned investment: I = 38
(3) Government spending: G = 75
(4) Exports: EX = 25
(5) Imports: IM = .05 Yd
(6) Disposable income: Yd = Y - T
(7) Taxes: T = 40
(8) Planned aggregate expenditure:
AE C + I + G + EX - IM
(9) Definition of equilibrium income: Y = AE 3.
a. What is equilibrium income in Hypothetica? What is the government deficit? What is the current account balance?
b. If government spending is increased to G = 80, what happens to equilibrium income? Explain using the government spending multiplier. What happens to imports?
c. Now suppose the amount of imports is limited to IM = 40 by a quota on imports. If government spending is again increased from 75 to 80, what happens to equilibrium income? Explain why the same increase in G has a bigger effect on income in the second case. What is it about the presence of imports that changes the value of the multiplier?
d. If exports are fixed at EX = 25, what must income be to ensure a current account balance of zero? (Hint: Imports depend on income, so what must income be for imports to be equal to exports?) By how much must we cut government spending to balance the current account? (Hint: Use your answer to the first part of this question to determine how much of a decrease in income is needed. Then use the multiplier to calculate the decrease in G needed to reduce income by that amount.)
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.