Textbook Problem

Consider an economy described by the following equations:

       Y = C + I + G

       C = 100 + 0.75(Y – T)

       I = 500 – 50r

       G = 125

       T = 100

where Y is GDP, C is consumption, I is investment, G is government purchases, T is taxes, and r is the interest rate. If the economy were at full employment (that is, at its natural rate), GDP would be 2,000.

1. a. Explain the meaning of each of these equations.
2. b. What is the marginal propensity to consume in this economy?
3. c. Suppose the central bank’s policy is to adjust the money supply to maintain the interest rate at 4 percent, so r = 4. Solve for GDP. How does it compare to the full-employment level?
4. d. Assuming no change in monetary policy, what change in government purchases would restore full employment?
5. e. Assuming no change in fiscal policy, what change in the interest rate would restore full employment?

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