Hong Kong Polytechnic University

School of Accounting and Finance

AF1605
INTRODUCTION TO ECONOMICS
WRITTEN REPORT
Second Semester 2014/2015

STUDENT ID:13064026D
STUDENT NAME: YUNG MO WAI

TUTORIAL:TUT 3
INSTRUCTOR: BETTY NGAI
Question Set8
8.1

Suppose that the economy of FarFarAway is described by the following

equations:
i.
Planned consumption:
C = 1000+0.8(Y-T)
ii.
Planned investment:
I = 2000-1000r
iii.
Planned government expenditure: G = 2000
iv.
Planned net export:
NX = 90
v.
Income taxes:
T = tY
vi.
Income tax rate:
t=0.20
vii.
Real interest rate:
r = 0.05
viii. Potential output:
Y = 15000
a. What is the short-run equilibrium output for FarFarAway? Please show
your calculation.
b. Briefly explain how the government of FarFarAway can change from
the short-run equilibrium output (i.e. your answer to (a)) to the potential
output using fiscal policy. In your answer, please state only one tool
that the government can use to implement this policy and explain how
it can affect output.
f

8.1a
At equilibrium, AE(aggregate expenditure) equals to the Y(equilibrium).
Aggregate Expenditure is defined as the current value of all the finished goods
and services in the economy. The aggregate expenditure is thus the sum total of
all the expenditures undertaken in the economy by the factors during a given time
period. It refers to the expenditure incurred on consumer goods, planned
investment and the expenditure made by the government in the economy. In an
open economy scenario, the aggregate expenditure also includes the difference
between the exports and the imports.

When the economy is in equilibrium between aggregate expenditure and

GDP,say, AE=Y, and which will form a 45 degree line. We could form the
aggregate expenditure line by adding all up the values for consumption(C),
planned investment(I), government expenditure(G), and the net exports(NX). And
I+G+Nx always has the same value regardless of GDP, but consuption has a
positive intercept wuth a positive slope because real GDP is same as income
received, and the consumers will pay a portion of this income on prodcuts and
have the saving. Therefore, when GDP rises, C will also increase, but the other
elements(I+G+NX) remain unchanged.
i.e. AE= C + I + G + NX
By substitution and the given values,
AE=1000+0.8(Y-0.2Y)+2000+2000-1000(0.05)+90
AE=5040+0.64Y
At equilibrium,AE=Y,
Y=5040+0.64Y

Y=14000
After calculation, the short-run equilbrium output(Y) is 14000.

8.1b
It is asking to make the short-run equilibrium to become the potential output using
fiscal policy. There are two kinds of fiscal policy, expansionary and contractionary.
For expansionary fiscal policy, it has to increase the government expenditure and
decrease the taxation. Contractionary fiscal policy is that make decrease in
governmnet expenditure and make an increase in taxation. By expansionary
fiscal policy, we can reduce the tax rate to fulfill the requirement. Therefore, we
have to substitute Y as Y (15000)and make the tax rate become a unknown.
Say,
AE= C+I+G+NX, AE=Y =15000,
15000=1000+0.8(15000-tx15000)+2000-1000(0.05)+2000+90
15000=5040+12000-12000t
t=0.17
By comparing the original tax rate, the tax rate should be reduced by 3% and
makes the short-run equilibrium become the potential output.
f

On the other hand, increase the government expenditure.

We have to put Y as Y (15000) and keep the government expenditure(G) as
unknown.
f

15000=1000+0.8(15000-0.2x15000)+G-1000(0.05)+2000+90
15000=3040+G+9600
15000=12640+G
G=2360
By comparing the original government expenditure, it should be increased by 360
and makes the short-run equilibrium become the potential output.
Diagram showing the influence when G is increased:

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