Multiplier and Fiscal Policy

Consider a closed economy. The aggregate consumption function is given by the following expression:

C = 3 + 0.6Y

1. Express the aggregate demand YD of this economy as a function of G and I.

2. Plot the aggregate demand in the (YD, Y ) - space.

3. Find the equilibrium of the goods market.

4. Let G increase by one unit. How does the equilibrium change? Show the dynamics of G on the graph.

Assume another economy in which the aggregate consumption function is given by the following expression:

C = 3 + 0.4Y

1. Plot the aggregate demand on the same graph you plotted before.

2. Show on the graph an expansion in government spending of one unit.

3. Compare the changes in the equilibrium level of revenue of the two economies.

4. Express the equilibrium level of revenue of each economy as a function of G and I. How is this relationship called? What does it represent?

5. Calculate the fiscal mutiplier for both situations. For which economy corresponds the biggest value? Explain the reason of this difference and its implications.

6. What happens if the fiscal multiplier is bigger than 1? What happens if the fiscal multiplier is smaller than 1?