Aggregate Expenditure Homework (Key)

1) Autonomous consumption expenditure (a) in Pago Pago is $100 billion, and the marginal propensity
to consume (MPC) is 0.9. Investment (I) is $460 billion, government purchases of goods and services
(G) are $400 billion, and taxes (T) are a constant $400 billion (they do not change with income).
Assume that in Pago Pago there are no imports or exports.

A) What is the equation for Pago Pago’s consumption function? Keeping in mind that consumption
depends on disposable income (YD = Y – T), what would the level of consumption be if real GDP
were $4 trillion? [2 points]

The consumption function is an equation that relates the amount of money households spend on
consumption to their disposable income. In this case, the consumption function is

C  a  MPC  YD  a  MPC (Y  T )  100  0.9 Y  T  .

It would also be acceptable to write it as

C  100  0.9(Y  400) ,

as

C  100  0.9(YD ) ,

where YD represents disposable income, or even as

C  260  MPC  Y .

If Y were $4 trillion, you’d calculate the actual level of consumption as follows:

C  100  0.9  4000  400   3340 ,

which corresponds to $3.34 trillion worth of consumption.

Assignments can be turned in up to one class period late for half credit. 1/4
 B) What is the equation for Pago Pago’s aggregate expenditure curve? What level of output is
associated with macroeconomic equilibrium. [2 points]

Recognizing that AE  C  I  G , and that I = $460 and G = T = 400, you get that

AE  C  I  G ,
  a  MPC Y  T   I  G,
 100  0.9(Y  400)  460  400,
 600  0.9Y .

You know that you’re at macro equilibrium when AE  Y . Plugging this into our equation for
AE you find that

Y  600  0.9Y ,
0.1Y  600,
Y  6000.

So the economy will be producing $6 trillion worth of goods and services at macro equilibrium.

C) If investment falls to $360 billion, what is the change in equilibrium expenditure and what is the
size of the investment multiplier? [1 point]

You know that the change in Y can be calculated using the following equation:

 1 
Y  I  ,
 1  MPC 
 1 
 100  ,
 1  0.9 
 1000,

1
or $1 trillion. From this you can also see that the investment multiplier is equal to  10 .
1  0.9

2) A) Referring back to problem 1, briefly explain what is happening to inventories if Pago Pago real
GDP is $4 trillion? [1 point]

If Y were $4 trillion, you’d be to the left of the macro equilibrium on the AE diagram. At a point
like this, desired expenditure is greater than output, so inventories fall, prompting firms to
increase production until the economy returns to macro equilibrium at $6 trillion.

B) Briefly explain what is happening to inventories if Pago Pago real GDP is $8 trillion? [1 point]

Here you have just the opposite problem. If Y were $8 trillion you’d be to the right of the macro
equilibrium on the AE diagram. At a point like this, desired expenditure is less than output, so
inventories grow, prompting firms to decrease production until the economy returns to macro
equilibrium at $6 trillion.

2/4
3) Suppose the government of Bora Bora finances all of its expenditures using lump-sum taxes.
Suppose further that it has recently cut taxes by $100 million and that this tax cut led to a $150
million increase in real GDP. Calculate the marginal propensity to consume for Bora Bora and the
lump-sum tax multiplier. [1 point]

You know that T  100 and that Y  150 . And you know the equation you use to find the change
in Y that follows from a change in lump-sum taxes is

  MPC 
Y  T  .
 1  MPC 

All you need to do is to solve the above equation for MPC.

  MPC 
150  100  
 1  MPC 
1  MPC 150  100   MPC 
150  150 MPC  100MPC
150  250MPC
MPC  0.6

That, in turn, means that the lump-sum tax multiplier is

  MPC 
   1.5 .
 1  MPC 

3/4
In answering problems 1 through 3, you could assume that there was no international trade (i.e., X = M =
MPI = 0). To answer the following question, assume that

AE  C  I  G   X  M  ,

where C  a  MPC   Y  T  and M  MPI  Y .

4) The following data are reported for the economy of Mos Eisley. Use these data to find the macro
equilibrium value of real GDP. [2 points]

Autonomous Consumption (a) 1000

Investment (I) 500
Government Spending (G) 2000
Taxes (T) 2000
Exports (X) 500
Marginal Propensity to Consume (MPC) 0.8
Marginal Propensity to Import (MPI) 0.1

You know that

AE  C  I  G  X  M ,
  a  MPC Y  T    I  G  X  MPI  Y .

You also know that at the macro equilibrium AE = Y. Substituting this into the above equation
tells you that

Y   a  MPC Y  T    I  G  X  MPI  Y .

Now you just have to plug in your values for a, G, T, X, MPC, and MPI and solve for Y to find the
answer:

Y  1000  0.8 Y  2000    500  2000  500  0.1Y ,

0.3Y  2400,
Y  8000.

4/4