Problems
Formulas:
ΔC
MPC=
ΔY
where ΔC is the change in consumption, and ΔY is the change in income.
ΔY
Multiplier=
ΔI
Refers to how a change in investment (ΔI) leads to a change in national income or output.
1 1
Or Multiplier= =
1-MPC 1-c
New equilibrium = △Y0 = Y’0 − Y0
1. Suppose the consumption function is given by C =100 +.8Y, while investment is
given by I =50
a. What is the equilibrium level of income in this case?
b. What is the level of saving in equilibrium?
c. If, for some reason, output is at the level of 800, what will the level of involuntary
inventory accumulation be?
d. If I rises to 100 what will the effect be on the equilibrium income?
e. What is the value of the multiplier, , here?
f. Draw a diagram indicating the equilibria in both (a) and (d).
a. Consumption function: 𝐶=100+0.8𝑌
Solution:
Investment (autonomous): 𝐼=50
Basic AD model without G and NX
AD=C+I
= 100+0.8Y+50
= 150+0.8Y
Equilibrium condition: Y=AD
Y=150+0.8Y
Y-0.8Y=150
0.2Y=150
Y=150/0.2
Y= 750
b. Since TA=TR=0, it follows that S=YD-C=Y-C
S=Y-C
S=Y-(100+0.8𝑌)
S=Y-0.8Y-100
S=0.2Y-100
S=0.2(750)-100
S=150-100=50
or
S=Y-C
C=100+0.8Y
C=100+0.8(750)
C=100+600=700
S=750-700= 50
c. If the level of output is Y=800, then
C=100+0.8Y
C=100+0.8(800)
C=100+640=740
AD=C+I
AD=740+50=790
UI=Y-AD
UI=800-790=10
This means firms are producing more than is being purchased.
d. AD’=C+I’
AD’= 100+0.8Y+100
AD’= 200+0.8Y
Equilibrium condition: Y=AD’
Y=200+0.8Y
Y-0.8Y=200
0.2Y=200
Y=200/0.2
Y= 1000
e. 𝐶=100+0.8𝑌
MPC or c= 0.8
Multiplier= 1/1-c
= 1/1-0.8
= 1/0.2= 5
f.
AD=Y
AD
AD1=200+0.8Y
AD0=150+0.8Y
200
150
750 1000 Income, Y
2. Suppose the consumption behavior in problem 1 changes so that C =100 + .9Y,
while I remains at 50.
a. Is the equilibrium level of income higher or lower than it was in problem 1(a)?
Calculate the new equilibrium level, Y’, to verify this.
b. Now suppose investment increases to I =100, just as in problem 1(d). What is the new
equilibrium income?
c. Does this change in investment spending have more or less of an effect on Y than it
did in problem 1? Why?
d. Draw a diagram indicating the change in equilibrium income in this case.
a. Consumption function: 𝐶=100+0.9𝑌
Solution
Investment (autonomous): 𝐼=50
Basic AD model without G and NX
AD=C+I
= 100+0.9Y+50
= 150+0.9Y
Equilibrium condition: Y=AD
Y=150+0.9Y
Y-0.9Y=150
0.1Y=150
Y=150/0.1
Y= 1500
Since the MPC has increased from 0.8 to 0.9, the size of the multiplier is now larger and we
should therefore expect a higher equilibrium income level than in 1.a
b. Y=1500; Y’=?
I= 50; I’= 100 so ∆ I= 50
ΔY
Multiplier=
ΔI
1
Multiplier= = 1/1-0.9=10
1-c
Y= I
△Y0 = Y’0 − Y0
Y= 10x50= 500
500=Y’-1500
Y’= 2000
c. Y= I
Y= 5x50= 250
Y’= 10x50= 500
Since the size of the multiplier has doubled from 5 to 10, the change in output (Y) that
results from a change in investment (I) now has also doubled from 250 to 500.
d. AD=Y
AD AD1=200+0.9Y
AD0=150+0.9Y
200
150
Income, Y
1500 2000
3. Now we look at the role taxes play in determining equilibrium income. Suppose we
have an economy described by the following functions:
C =50 +.8YD
I =70
G=200
TR=100
t=0.20 or 20%
a. Calculate the equilibrium level of income and the multiplier in this model.
b. Calculate also the budget surplus, BS.
c. Suppose that t increases to .25. What is the new equilibrium income? The new
multiplier?
d. Can you explain why the multiplier is 1 when t= 1?
Solution
a. AD=C+ I +G
AD=50+.8 YD +70+200
AD= 320+.8[(1-.20)Y+100]
AD= 320+0.8[(0.8)Y+100]
e. AD= 320+0.64Y+80
AD= 400+.64Y
Equilibrium
Y=AD
Y=400+.64Y
Y-0.64Y=400
0.36Y=400
Y=1111.11
Multiplier= 1/1-c
=1/1-0.64
=2.777 or 2.78
c. AD=C+ I +G
AD=50+.8 YD +70+200
AD= 320+.8[(1-.25)Y+100]
AD= 320+0.8[(0.75)Y+100]
AD= 320+0.6Y+80
AD= 400+0.6Y
Equilibrium
Y=AD
Y=400+.6Y
Y-0.6Y=400
0.4Y=400
Y’=1000
Multiplier= 1/1-c
=1/1-.6
=1/0.4
= 2.5
The size of the multiplier is now reduced to 2.5.
d. If the income tax rate is t = 1, then all income is taxed. There is no induced spending and
equilibrium income only increases by the change in autonomous spending, that is, the size of
the multiplier is 1.