Question

You are given the following model that describes the economy of Hypothetica.

• Consumption function: C=100 + .8Y_d
• 2) Planned investment: I = 38
• 3) Government spending: G = 75
• 4) Exports: EX = 25
• 5) Imports: IM = .05 Y_d
• 6) Disposable income: Y_d ≡ Y - T
• 7) Taxes: T = 40
• 8) Planned aggregate expenditure: AE ≡ C + I + G + EX - IM
• 9) Definition of equilibrium income: Y = AE

1. What is equilibrium income in Hypothetica? What is the government deficit? What is the current account balance?
2. If government spending is increased to G = 80, what happens to equilibrium income? Explain using the government spending multiplier. What happens to imports?
3. Now suppose the amount of imports is limited to IM = 40 by a quota on imports. If government spending is again increased from 75 to 80, what happens to equilibrium income? Explain why the same increase in G has a bigger effect on income in the second case. What is it about the presence of imports that changes the value of the multiplier?
4. If expects are fixed at EX = 25, what must income be to ensure a current account balance of zero? (Hint - imports depend on income, so what must income be for imports to be equal to exports?) By how much must we cut government spending to balance the current account? (Hint - Use your answer to the first part of this question to determine how much of a decrease in income is needed. Then use the multiplier to calculate the decrease in G needed to reduce income by that amount.)