Questions Expenditure Multiplier Model - Key

Assignment Question: Multiplier Model
1. Suppose the consumption function is given by C= 100+ .8Y, while investment is given
by I = 50. There is no government, and economy is closed.
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/depletion be?
d. If I rises to 100, what will the effect be on the equilibrium income?
e. What is the value of the multiplier, α, here?
f. Draw a diagram indicating the equilibria in both (a) and (d).
AD = C + I = 100 + (0.8)Y + 50 = 150 + (0.8)Y

The equilibrium condition is Y = AD ==>
Y = 150 + (0.8) Y ==> (0.2)Y = 150 ==> Y = 5*150 = 750.
b. Since TA = TR = 0, it follows that S = YD - C = Y - C. Therefore

S = Y - [100 + (0.8) Y] = - 100 + (0.2) Y ==> S = - 100 + (0.2)750 = - 100 + 150 = 50.
As we can see S = I, which means that the equilibrium condition is fulfilled.
c. If the level of output is Y = 800, then AD = 150 + (0.8)800 = 150 + 640 = 790.
Therefore the amount of involuntary inventory accumulation is
UI = Y - AD = 800 - 790 = 10.
d. AD' = C + I' = 100 + (0.8)Y + 100 = 200 + (0.8)Y

From Y = AD' ==> Y = 200 + (0.8)Y ==> (0.2)Y = 200 ==> Y = 5*200 = 1,000
Note: This result can also be achieved by using the multiplier formula:
Y = (multiplier)(I) ==> Y = 5*50 = 250,
that is, output increases from Yo = 750 to Y1 = 1,000.
e. From 1.a. and 1.d. we can see that the multiplier is α = 5.
f.
AD Y = AD
AD1 = 200 = (0.8)Y
ADo = 150 + (0.8)Y
200
150
0
750 1,000 Y
2. Suppose the consumption behavior in the previous problem changes so that C = 100 +
.9 Y, 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 8 (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 8? Why?
d. Draw a diagram indicating the change in equilibrium income in this case.
a. Since the mpc has increased from 0.8 to 0.9, the size of the multiplier is now larger. Therefore we
should expect a higher equilibrium income level than in (8.a).
AD = C + I = 100 + (0.9)Y + 50 = 150 + (0.9)Y ==>
Y = AD ==> Y = 150 + (0.9)Y ==> (0.1)Y = 150 ==> Y = 10*150 = 1,500.
b. From Y = (multiplier) (I) = 10*50 = 500 ==> Y1 = Yo + Y = 1,500 + 500 = 2,000.
c. Since the size of the multiplier has doubled from α = 5 to α1 = 10, the change in output (Y) that
results from a change in investment (I) now has also doubled from 250 to 500.
d. Y = AD
AD
AD1 = 200 = (0.9)Y
ADo = 150 + (0.9)Y
200
150
0
1,500 2,000 Y
3. Suppose the economy is operating at equilibrium, with Y0 = 1,000. If the government
undertakes a fiscal changes whereby the tax rate ,‘t’, increases by .05 and government
spending increases by 50, will the budget surplus go up or down ? Why?
Hint: Try with some numbers: (e.g. Assume: Yo = 1,000, to = 0.25, Go = 200, C= 100+ .8YD)
On first sight, one may want to conclude that this is an application of the balanced budget
theorem, since, as long as Y = 1,000, a change in the tax rate by 5% will cause tax revenues
to change by ∆TA = 50, which is the same as the change in government purchases, that is,
∆G = 50. As long as income (Y) stays the same, the budget surplus will not be affected.
However, this combined fiscal policy change will have an effect on national income and,
since national income goes up, so does the government’s tax revenue, due to the fact that
we have income taxation. Therefore we should expect an increase in the budget surplus.
This can easily be shown with a numerical example.
Assume: Yo = 1,000, to = 0.25, Go = 200, C= 100+ .8YD, then
Multiplier = 1/(1-c(1-t)) = 1/(1-0.8(1-.25)) = 1/0.4 =2.5
Since Y is 1000, would be A = 400 (I would automatically be 100)
Now with G increasing by 50, and tax rates going up by 5%

A = 450, Multiplier = (1/(1- 0.8(1- 0.3)) = 1/0.44 = 2.27
Y = 450 * 2.27 = 1022.77
Income tax: 1022.77 * 0.3 = 306.81
Previous income tax = 250
Change in fiscal/budget deficit = 306.81 – 250 – 50 = 6.81
Therefore we see that the budget surplus has increased, since the increase in total
income tax revenue is larger than the increase in government purchases.

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Assignment Question: Multiplier Model

AD = C + I = 100 + (0.8)Y + 50 = 150 + (0.8)Y

b. Since TA = TR = 0, it follows that S = YD - C = Y - C. Therefore

d. AD' = C + I' = 100 + (0.8)Y + 100 = 200 + (0.8)Y

e. From 1.a. and 1.d. we can see that the multiplier is α = 5.

ADo = 150 + (0.8)Y

AD = C + I = 100 + (0.9)Y + 50 = 150 + (0.9)Y ==>

Y = AD ==> Y = 150 + (0.9)Y ==> (0.1)Y = 150 ==> Y = 10*150 = 1,500.

b. From Y = (multiplier) (I) = 10*50 = 500 ==> Y1 = Yo + Y = 1,500 + 500 = 2,000.

ADo = 150 + (0.9)Y

Now with G increasing by 50, and tax rates going up by 5%

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