ECON 204 Suppose that the consumption function for the economy is: C = 400 + 0.6(Y-T) The investment function is: I = 300 – 20r Government Spending is equal to 300 and the government runs a balanced budget. Output is equal to 1,675. a) What is the

Suppose that the consumption function for the economy is:

C = 400 + 0.6(Y-T)

The investment function is:

I = 300 – 20r

Government Spending is equal to 300 and the government runs a balanced budget. Output is equal to 1,675.

a) What is the real interest rate for this economy? What share of output is spent on consumption?

b) What is the effect of a deficit financed increase in government spending on consumption, investment, the real interest rate, government spending and output? Use a diagram with savings and investment on the horizontal axis and the real interest rate on the vertical axis in your answer.

c) Now suppose that taxes are equal to:

T = 0.2Y

This is different than the case studied in class because taxes are proportional to income. What is the equilibrium real interest rate in this economy? Is the government running a surplus or a deficit?

d) Suppose that the Central Bank successfully implements an inflation targeting regime. What is the effect of the deficit financed increase in government spending from part b) on the demand for real money balances?

Sample Solution