Question

(Related to Solved Problem 23.4 on page 807 ) Use the information in the following table to answer the questions. Assume that the values represent billions of 2009 dollars. $$ \begin{array}{r|r|r|r|r} \hline \begin{array}{c} \text { Real } \\ \text { GDP } \\ (Y) \end{array} & \begin{array}{c} \text { Planned } \\ \text { Consumption } \end{array} & \begin{array}{c} \text { Investment } \\ \text { (C) } \end{array} & \begin{array}{c} \text { Government } \\ \text { Purchases } \end{array} & \begin{array}{c} \text { Net } \\ \text { Exports } \end{array} \\ \hline \$ 8,000 & \$ 7,300 & \$ 1,000 & (G) & (N X) \\ \hline 9,000 & 7,900 & 1,000 & 1,000 & -\$ 500 \\ \hline 10,000 & 8,500 & 1,000 & 1,000 & -500 \\ \hline 11,000 & 9,100 & 1,000 & 1,000 & -500 \\ \hline 12,000 & 9,700 & 1,000 & 1,000 & -500 \\ \hline \end{array} $$ a. What is the equilibrium level of real GDP? b. What is the MPC? c. Suppose net exports increase by \(\$ 400\) billion. What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer.

Short answer

a. The equilibrium level of real GDP is $10000 billion. b. The MPC is 0.6. c. The new equilibrium level of real GDP with an increase of $400 billion in net exports is $11000 billion.

Step-by-step solution

Calculate Equilibrium Level of Real GDP

First we calculate the equilibrium level of real GDP which is where Y = C + I + G + NX. From the table, we see this is true in the case of Y = $10000, as 8500 (C) + 1000 (I) + 1000 (G) - 500 (NX) = $10000.

Calculate MPC

Next, we calculate the marginal propensity to consume (MPC). MPC is the slope of the consumption function, or the change in C divided by the change in Y. Look for two rows in the table where change in GDP (Y) and change in consumption (C) can be calculated. For instance from Y = $9000 to Y = $10000, ∆C = $600 and ∆Y = $1000. Therefore, MPC = ∆C / ∆Y = 600 / 1000 = 0.6.

Determine the Multiplier

To evaluate the impact of change in net exports on GDP, we need to use the multiplier. The formula for the multiplier is 1 / (1-MPC). Substituting the value of MPC, multiplier = 1 / (1-0.6) = 2.5.

Calculate New Equilibrium GDP with Increased Net Exports

Supposing net exports increase by $400 billion, we can calculate the change in equilibrium GDP using the formula ∆Y = multiplier x ∆NX. Substituting the values, ∆Y = 2.5 x 400 = $1000 billion. Add this to the original equilibrium GDP, the new GDP = $10000 + $1000 = $11000 billion.

Key concepts

Marginal Propensity to Consume (MPC)

Understanding the Marginal Propensity to Consume (MPC) is crucial in grasping how households in an economy are likely to adjust their consumption habits in response to changes in their income levels. Simply put, the MPC represents the proportion of additional income that a household will spend on consumption rather than saving it.
To calculate the MPC, we observe the change in consumption (\text{\textbackslash Delta C}) and compare it to the change in income (\text{\textbackslash Delta Y}). For example, if a household's income increases by \(1,000 and they spend \)600 of this additional income, the MPC is 0.6. This tells us that for every dollar of new income, the household consumes 60 cents and saves the remaining 40 cents.

GDP Multiplier

The GDP Multiplier is a powerful concept that reveals the magnified impact of an initial change in spending on the overall level of economic activity. It is based on the idea that one person's spending becomes another person's income, which leads to more spending and income, and so on.
To determine the multiplier, use the formula \text{\textbackslash frac\text{1\textbackslash end}\text{1 - MPC}\text}}. In an economy with an MPC of 0.6, the GDP Multiplier would be \text{\textbackslash frac\text{1\textbackslash end}\text{1 - 0.6}\text}}, or 2.5. This suggests that a \(1 increase in spending could potentially result in a \)2.50 increase in real GDP, due to the chain reaction of spending. However, the actual impact depends on various factors including the overall economic climate and capacity constraints.

Net Exports

Net Exports, a component of the equation for GDP, is the value of a country’s total exports minus the value of its total imports. It is an important indicator of an economy's health and can influence its level of real GDP. When net exports are positive, the country exports more than it imports, contributing to higher GDP. Conversely, negative net exports, where imports exceed exports, will decrease GDP.
Changes in net exports can emanate from factors such as currency fluctuations, trade policies, and global economic trends. An increase in net exports, for instance, can trigger a higher equilibrium GDP. As seen in the exercise, a \(400 billion rise in net exports increases the real GDP by \)1,000 billion when factoring in the multiplier effect. This demonstrates the significant influence international trade has on domestic economic growth.