Question

If the consumption function is C = 100 + 0.75YD, I = 200, government spending is 200, and net exports are zero, what will be the equilibrium level of output?

What will happen to aggregate output if government spending rises by 100?

Short answer

Equilibrium level of output = 2000

With Increase in government spending, equilibrium level of output = 2400

Step-by-step solution

Equilibrium Concept 

Economy is at equilibrium, where aggregate demand is equal to aggregate supply.

Aggregate Demand is the total value of output - that sectors of economy (firms, households, government, rest of the world) are planning to buy, at level of income & period of time.

AD = Consumption + Investment + Government Expenditure + Net Exports

Aggregate Supply is the total value of output - all producers of economy are planning to sell, at level of income & period of time. AS value IS equal to National Income

Numerical Solution 

• AD = C + I + G + NX

= 100 + 0.75Y + 200 + 200 + 0

AD = 500 + 0.75Y

• AS = Y

So,Equilibrium is at where -

AD = Y

500 + 0.75Y = Y

Y - 0.75Y = 500

0.25Y = 500

Y = 500 / 0.25

Y = 2000

Change in Government Spending 

G' = New Government Expenditure = 200 + 100 = 300

New AD = C + I + G' + Nx

New AD = 100 + 0.75Y + 200 + (200 + 100) + 0

AD = 600 + 0.75Y

• New Equilibrium

New AD = Y

600 + 0.75Y = Y

600 = Y - 0.75Y

600 = 0.25Y

Y = 600 / 0.25

Y = 2400