SAMPLE FINAL EXAM QUESTION 4

ChangMing & LiangWei

Group 2

Comprehensive Quantitative Question

Assumptions

Assumption 1: There is no tax and assume the economy

has fixed exchange rate. Both consumption and import
are increasing function of aggregate income. That is C
= a + MPCY and IM = f + MPM Y, where a and f
are positive constants.
Assumption 2: For every 1% increase (decrease) in the
interest rate, planned investment I decreases (increases)
by $0.2 billion.
Assumption 3: For every $1 billion increase (decrease)
in government spending G, the interest rate increases
(decreases) by 1%.

4.1
What

is the definition of equilibrium in the

goods market? Using this definition, derive
MPC and MPM mathematically according
to Figure 1 and Assumption 1. (8 marks)
At equilibrium,
AD (Y) = AE
AD = C + I + G + X - M

Using this definition, derive MPC and MPM

mathematically according to Figure 1 and Assumption 1.
AD

=C+I+G+X-M

C
MPC =
Y
M
MPM =
Y

Using this definition, derive MPC and MPM

mathematically according to Figure 1 and Assumption 1.
In

a closed economy,

AE

=C+I+G
From assumption 1, C = a + MPC x Y
Using b = MPC
AE = (a+bY) + I + G
At eqm, Y = AE = (a+bY) + I + G

1
1
1
Y=
a+
I+
G
1 b
1 b
1 b

Using this definition, derive MPC and MPM

mathematically according to Figure 1 and Assumption 1.
From the graph, when Y = 0, AE =20
AE = (a+bY) + I + G
20 = a + I + G
When Y =100, AE = 100
100 = a + b(100) + I + G
100 = 100b + a + I +G
100b = 80
b = MPC = 0.8

Using this definition, derive MPC and MPM

mathematically according to Figure 1 and Assumption 1.
In an open economy,
AE = C+I+G+EX-IM
From assumption 1, IM = f + MPM x Y
Using d=MPM,
AE = (a+bY) + I +G + EX (f + dY)
When Y =0 and AE =20,
20 = a + I + G + EX f
When AE=25 and Y =25
25 = a + 25b + I + G + EX f 25d
25 = a + I + G + EX + 25(0.8) 25d
25d = 20 + 20 25 = 15
d = MPM = 0.6

4.2
Holding

money supply constant, according to

Assumptions 2 and 3, when government spending
increases by $3 billion, what happens to the interest
rate and planned investment?
(2 marks)

Assumption 2: For every 1% increase (decrease) in the

interest rate, planned investment I decreases (increases)
by $0.2 billion.
Assumption 3: For every $1 billion increase (decrease)
in government spending G, the interest rate increases
(decreases) by 1%.

4.2

Government spending
increases by $3 billion.

3% increase in interest
rate

Investment decrease by
$0.6billion

4.3

Taking this crowding-out effect into consideration, if

government spending increases by $3 billion, how
much will be the new equilibrium aggregate output if
this is a closed economy? And how much will it be if
this is an open economy?
(8 marks)

4.3
Closed Economy
YG =

1
G
1 MPC

1
YI =
I
1 (MPC)

Ynet =YG +YI

Open Economy
YG =

1
G
1 (MPC MPM )

YI =

1
I
1 (MPC MPM )

Ynet =YG +YI

4.3

In a closed economy,

1
1
1
Y=
a+
I+
G
1 b
1 b
1 b
1
1
Y=
(0.6) +
(3) = 12
1 0.8
1 0.8

When G increases by 3 billion and I decreases by

0.6 billion

1
1
Y=
(0.6) +
(3) = 12
1 0.8
1 0.8

4.3

In an open economy,

Y=

1
1
1
1
1
a+
I+
G+
EX
f
1 (MPC MPM ) 1 (MPC MPM ) 1 (MPC MPM ) 1 (MPC MPM )
1 (MPC MPM )

Y=

1
1
1
1
1
a +
I +
G +
EX
f
1 (MPC MPM ) 1 (MPC MPM ) 1 (MPC MPM )
1 (MPC MPM )
1 (MPC MPM )

When G increases by 3 billion and I decreases by

0.6 billion

Y=

1
1
I +
G
1 (MPC MPM )
1 (MPC MPM )

1
1
Y=
(0.6) +
(3) = 3
1 (0.8 0.6)
1 (0.8 0.6)

4.4

Why does the same increase in government

spending have a larger effect on equilibrium output
in a closed economy than in an open economy?
Explain intuitively.
(4 marks)

4.4
Closed Economy
Increase in government spending will
increase the circular flow of income in
that particular economy.
Y = C + I +G

Open Economy
Increase in government spending by the
same amount will increase the circular
flow of income by a smaller amount.
Some of extra government spending
that results is on foreign products and
not on home produced goods and
services
This results in a smaller Y in
Y = C + I +G + X - M

4.4
Closed Economy
Multiplier:

1
1 MPC

Open Economy
Multiplier:

1
1 (MPC MPM )

Magnitude of the multiplier

Closed economy > Open economy

Questions?