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Exam 11: The Multiplier Model

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Question 1

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Assume that the economy is initially at an income level of $1,000 and the potential income level is $1,200.How can government fiscal policy be used to get the economy out of this recession? Why might this policy not work in real life?

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The government can pull the economy out ...

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Question 2

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Describe the basic difference between the AS/AD model and the multiplier model.

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The AS/AD model gives us insights into the qualitative effects of changes in aggregate expenditures whereas the multiplier model tells us about their quantitative effects.

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The mpe for the economy is 0.67.Autonomous consumption is $500,investment is $300,government spending is $250,and net exports are -$100. (a)What is equilibrium income for the economy? (b)If government policies were able to eliminate the trade deficit (and make net exports zero)without affecting anything else,what impact would that have on the equilibrium level of income? (c)Suppose that the policies to increase exports in part (b)also had the effect of increasing investment by $50,and allowed the government to cut $30 in subsidies.Calculate the new equilibrium income.

Consider the following multiplier model diagram: For each of the following,draw a picture to show what would happen to the equilibrium level of income in the economy. (a)Consumer sentiment about the future improves resulting in an increase in autonomous consumption of 100. (b)Foreign economic activity rises,which results in an increase in autonomous exports of 100. (c)Because the average life span increases,many people are saving more of their income than ever before.Consequently the mpe falls from 0.75 to 0.66.

Suppose the government increases autonomous taxes (taxes that do not depend on income).What would happen to the AE curve? Explain.

For each of the following state the level of autonomous expenditures and induced expenditures. (a)Given the following table and income equals $200. $\begin{array} { | r | r | } \hline \text { Income } & \text { Eighenditures } \\\hline 0 & 100 \\\hline 100 & 150 \\\hline 200 & 200 \\\hline 300 & 250 \\\hline\end{array}$ (b)Given the following expenditures function AE = $4,000 + 0.6Y and income equals $1,000.

Answer parts (a)-(e)below based on the AE equation AE = 2,500 + 0.9Y. (a)What is the level of autonomous expenditures? (b)If income is 1,000 what is the level of induced expenditures? (c)What is the mpe? (d)What is the value of the multiplier? (e)What is the level of equilibrium income?

In the multiplier model all expenditures are classified as one of two types.Explain and give an example of each type of expenditure.

Consider the following multiplier model diagram: Is the income level of Y₀ an equilibrium level of income? If yes,explain why.If not,explain how the economy will get to equilibrium.

(a)Draw an aggregate production curve and explain why you have drawn it as you have.What is its slope? (b)Draw the aggregate expenditures curve that corresponds to the expenditures function: E = $2,000 + 0.6Y.Explain why you have drawn it as you have.What is its slope? (c)Label equilibrium income and explain why income levels above and below are points of disequilibrium.

Consider the following multiplier model diagram: Demonstrate graphically (and explain your graph)what will happen in the picture when the price level increases.Link this diagram to the AD/AS model by showing the effects of an increase in the price level in the AD/AS model.Assume a horizontal SAS curve.

(a)Demonstrate graphically and explain the implications of the permanent income hypothesis on the multiplier model. (b)How do changes in autonomous expenditures affect the change in income in this case?

What is the real business cycle theory of the economy?

Consider the following multiplier model: AE = 8,000 + 0.75Y,and potential output equals 35,000. (1)Calculate equilibrium output. (2)State what fiscal policy you would recommend to eliminate the inflationary or recessionary gap. (3)Calculate the change in government spending required to eliminate the gap.

Consider the following multiplier model: AE = 5,000 + 0.9Y,and potential output equals 45,000. (1)Calculate equilibrium output. (2)State what fiscal policy you would recommend to eliminate the inflationary or recessionary gap. (3)Calculate the change in government spending needed to eliminate the gap.

Demonstrate graphically and explain the AP curve in the multiplier model.

Consider the following multiplier model diagram: (a)What is the value of equilibrium income? (b)Demonstrate graphically and explain verbally the impact on equilibrium income of a decrease in exports of 50. (c)Explain why the change in equilibrium income exceeds the change in exports in your answer for part

Consider a multiplier model in which autonomous expenditures are $2,250 billion and the mpe is 0.8.Suppose that the President asks you to explain to him the impact that a $50 billion cut in government spending will have on the economy.Provide a mechanistic and an interpretive explanation.

Write the formula for the multiplier.What happens to the multiplier when the mpe gets larger?

Suppose consumers decide to spend less of every dollar of income earned than previously spent.What would happen to the AE curve? Explain.