Question

Consider a closed economy described by the following equations (all figures in millions of dollars): Y = C + + G Assume current value of output Y in this economy equals $8,000.00 Annual government expenditure equals $2,000.00 Current level of income tax is combination of flat Tax and income adjusted, based on following tax rate; 1,000 + .1(Y) Current annualized consumer spending equals to: 450 +0.75 (DI), were DI Disposable income = Income - Tax Current level of short term investment is fixed and equals to $2,000.00 NX = 0 a) Calculate the current state of private saving, public saving and current level of investment. What do the information you calculated tell you about the current state of the economy? b) Suppose the congress approve an infrastructure investment which raises government expenditure to 2,250. How would this increase impact your calculation in (a) above if government barrows the money verses raising tax to cover it? Now suppose the business community is optimistic about the future of economy and decide to increase the level of investment by 10%, how would the change in investment impact the economy in term of consumption, saving, taxes, etc.)? (hint; you want compare the result you get in (c) with what you calculated in (a)). Now suppose we actually have no idea of the current value of output Y, but the rest of information on C. I. G and income tax are as stated above. What will be the necessary level of output Y should be to insure equilibrium?

Answer 1

Y =$8000, G= $2000, T = 1000+.1Y = 1000+ .1*8000 = 1000+ 800 = 1800

I = 2000,   

C = Y – I – G = 8000- 2000-2000= 4000

C = 450+.75DI => 4000-450= .75DI => DI = 4733.33

a) Private saving = Y-T -C = $8000- $1800 – $4000 = $2200

Public saving = T – G = 1800- 2000 = -200

Current level of investment is $2000 in the economy; however, public saving is negative indicating government expenditure is greater than government revenue through tax. Government has budget deficit in this current situation.

b) As G increases from $ 2000 to $2250, budget deficit increases in the short run. However, it raises total output of the economy

Y = 4000+ 2000+ 2250 = $8250

If government borrows money instead of raising tax now, it must have to tax in future to pay out the debt in future. Therefore, public debt at current year will create tax burden for future generations.

c) If investment increases by 10% ; New I = 2000(1+.10) = $2200

Y = 8000 + (2200-2000) = $8200

Tax = 1000+ .1*8200 = $1820

C = 8200 – 2200 -2000 = $4000

Private saving = Y-T -C = 8200 – 1820 – 4000 = $2400

Public saving = 1820 – 2000 = -$180

d) Y = C+ I + G in equilibrium

If the values of the components are given, the adding the values the value of Y can be obtained.

C= $4000, I = $2000 and G = $2000

Y = 4000+2000+2000 = $8000