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Assignment - Keynesian Cross Solutions

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Assignment - Keynesian Cross Solutions

Uploaded by

yoursgauravsingh
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© © All Rights Reserved
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Assignment – Keynesian Cross and IS – Curve

1. Assume that the consumption function is given by C = 100 + 0.6(Y – T). If planned
investment is 100 and T is 100 and NX =0. Then the level of G needed to make
equilibrium Y equal 1,000 is ___.
A. 200.
B. 240.
C. 250.
D. 260. [x]

Y=C+I+G
 1000 = 100 + 0.6*(1000-100) +100 + G
 G = 1000 – 100 -540 – 100
 G = 260

2. Consider the following model:

Y=C+G+I
C = c0 + c1*YD; YD = Y-T
T = 50 , G = 150 , I = 100
with c0=10 and c1=0.5.

a) Compute equilibrium income, consumption and savings.

Ye = c0 + c1*(Ye – T) +G+I = 10+0.5(Ye – 50) + 150 +100


 0.5 Ye = 260-25 = 235
 Ye = 470

Ce = 10 +0.5(470-50) = 10+210 = 220


SP = Ye -T-Ce = 470-50-220 = 200; Sg = T=G = 50-150 = -100
Stotal = SP + Sg = 200-100 = 100 = I

b) Suppose the government asks consumers to save more. The consumers abide and
reduce c0 by 5. What happens to equilibrium income, consumption and saving?
Explain the intuition.

If c0 falls by 5 then –

Ye = c0 + c1*(Ye – T) +G+I = 5+0.5(Ye – 50) + 150 +100


 0.5 Ye = 255-25 = 230
 Ye = 460
Ce = 5 +0.5(460-50) = 5+205 = 210
SP = Ye -T-Ce = 460-50-210 = 200; Sg = T=G = 50-150 = -100
Stotal = SP + Sg = 200-100 = 100 = I

Equilibrium income and consumption decline but there is no change in overall savings. This
happened because as people reduced their spending on consumption, firms decided to cut
back on their production and workers got less income. This in turn means lower actual
consumption. Consumption falls by the same amount as income hence no change in savings.
This is known as the ‘paradox’ of savings. Trying to increase savings can actually end up
causing a decline in income with no change in savings.

c) Suppose government increases its spending G to 160 (G=160). How does this affect
the equilibrium output? Is the increase in equilibrium output higher or lower than
the increase in government spending ‘G’.? Explain the intuition.

Ye = c0 + c1*(Ye – T) +G+I = 10+0.5(Ye – 50) + 160 +100


 0.5 Ye = 270-25 = 245
 Ye = 490

Ce = 10 +0.5(490-50) = 10+220 = 230


SP = Ye -T-Ce = 490-50-230 = 210; Sg = T=G = 50-160 = -110
Stotal = SP + Sg = 210-110 = 100 = I

Increase in equilibrium output is higher than the increase in G (10 units). Because of the
multiplier effect – increase in government spending increases the disposable income and
hence consumption demand by households which in turn increases output further.

d) Use Keynesian cross function to show the impact of this increase in G on equilibrium
output.
PE PE=Y

PE2

PE1

Y
Y1 Y2

Increase in G shits the PE line upwards which in turn increases the equilibrium output in the
economy.

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