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Consider the following aggregate expenditure model of an economy:

C = 50 + (8/9)Yd T = (1/4)Y I = 100 G = 150 X = 100 IM = (1/3)Y

where C is consumption, Yd is disposable income, T is taxes, Y is national income, I is investment, G is government spending, X is exports, and IM is imports, all in billions of dollars.

(a) Solve for aggregate expenditure (AE) as a function of Y, and calculate the equilibrium level of national income. Illustrate your equilibrium in a diagram with AE on the vertical and Y on the horizontal axis. [Hint: Leave the fractions as fractions rather than decimals, your answer will work out nicely.] [8]

(b) Using your answer from (a), calculate the level of consumption spending and the level of private saving. Illustrate the private saving function (remember, S is a function of disposable income). Show the current level of saving. [6]

(c) Calculate the government's budget surplus or deficit at the equilibrium level of income. Calculate the trade balance (net exports). Illustrate the trade balance in a diagram of net exports as a function of national income. [6]

(d) Suppose that the government estimates that potential GDP for the economy is 750. By how much would the government have to increase its spending to achieve this level of GDP? Illustrate the effect of the increase in your diagram for part (a). What is effect on the government's budget? Does this result surprise you given the government's original budget situation?

(e) If we assume that the aggregate expenditure model is fully describing the reactions of the economy to the increase in government spending, what implicit assumption are we making about the aggregate supply curve? Illustrate in a diagram.

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