Your island economy has been thriving for many years now, and has grown large, with

many
people, services, goods, and trade available. In your island economy, you currently have no
government. You know the following information:

• People seem to spend about 80% of their income.

• People import (from a neighbouring island!) about 15% of their goods and services.

• Business Expenditure is currently at $2,000.

• Exports/year are worth $1,000

1. Determine the current level of equilibrium GDP.

2. You begin to develop a government on this island. You start with a net tax rate of 10%, and
government expenditure of $600. a. Determine the new level of equilibrium GDP.

b. Determine the budget balance.

3. There is a virus in a neighbouring economy, and as a result, your exports and imports both
drop to zero, respectively. Graph the impact of this on both your equilibrium GDP and budget
balance. What is our GDP now, and what is our budget balance?

4. It has been estimated that your potential GDP (𝑌𝑃) is approximately $12,000. Describe the
effects of your current equilibrium GDP and your potential GDP - what will happen in your
economy and why? What is our structural budget balance for this 𝑌𝑃?

5. To reach your potential GDP, describe any changes you - as the government - would make to
either your tax rate or your government expenditure. Graph the changes you describe and
determine the effects to GDP, Government expenditure, taxation, and budget balance.
1.

Current level of equilibrium GDP is $8571.42

2.

a.

The new equilibrium level of GDP is $8372.09

b.

The government is running a budget surplus of $237.209

3.

The new equilibrium level of GDP is $9285.71

The government is running a budget surplus of $328.571

4.

When actual GDP is less than potential GDP, households in the economy experience decline in
their standard of living.

The structural budget balance is $600

5.

I would increase government spending by $760, which would result in an increase in output by
$2714.29 thereby making output equal to potential output thus eliminating the recessionary
output gap.

GDP would increase by $2714.29. New level of GDP would be $12000

Government expenditure would increase by $760. The new level of government
expenditure would be $1360.

The new level of tax revenues is $1200

The government is running a budget deficit of $160

Explanation:

1. Determine the current level of equilibrium GDP.

People seem to spend about 80% of their income, thus marginal propensity to consume is 0.8

MPC = 0.8

C = MPC * Y

C = 0.80 * Y

People import (from a neighboring island!) about 15% of their goods and services, thus marginal
propensity to import is 0.15

M = 0.15 * Y

Business Expenditure is currently at $2,000, thus I = 2000

Exports/year are worth $1,000, thus X = 1000

There is no government, thus G = 0

Y=C+I+G+X-M

Y = 0.80 * Y + 2000 + 0 + 1000 - 0.15 * Y

Y = 0.65 * Y + 3000

Y - 0.65 Y = 3000

0.35 Y = 3000

Y = 3000/0.35

Y = 8571.42

The current level of equilibrium GDP is $8571.42

2. You begin to develop a government on this island. You start with a net tax rate of 10%,
and a government expenditure of $600. a. Determine the new level of equilibrium GDP.

Y=C+I+G+X-M

Y = 0.80 * Yd + 2000 + 600 + 1000 - 0.15 * Y [Where Yd = Disposable income]

Y = 0.80 * (Y - T) + 2000 + 600 + 1000 - 0.15 * Y

Y = 0.80 * (Y - 0.10 * Y)+ 2000 + 600 + 1000 - 0.15 * Y

Y = 0.80 * (0.90 * Y)+ 2000 + 600 + 1000 - 0.15 * Y

Y = 0.72 * Y + 2000 + 600 + 1000 - 0.15 * Y

Y = 0.57 * Y + 3600

Y - 0.57 Y = 3600

0.43 Y = 3600

Y = 3600 / 0.43

Y = 8372.09

The new equilibrium level of GDP is $8372.09

b. Determine the budget balance.

Budget balance = Government revenue - Government expenditure

Budget balance = [0.10 * Y] - 600

Budget balance = [0.10 * 8372.09] - 600

Budget balance = 837.209 - 600

Budget balance = 237.20

The government is running a budget surplus of $237.209

3. There is a virus in a neighboring economy, and as a result, your exports and imports
both drop to zero, respectively. Graph the impact of this on both your equilibrium GDP
and budget balance. What is our GDP now, and what is our budget balance?

Y=C+I+G+X-M

Y = 0.80 * Yd + 2000 + 600 + 0 - 0 [Where Yd = Disposable income]

Y = 0.80 * (Y - T) + 2000 + 600

Y = 0.80 * (Y - 0.10 * Y)+ 2000 + 600

Y = 0.80 * (0.90 * Y)+ 2000 + 600

Y = 0.72 * Y + 2000 + 600

Y = 0.72 * Y + 2600

Y - 0.72 Y = 2600

0.28 Y = 2600
Y = 2600 / 0.28

Y = 9285.71

The new equilibrium level of GDP is $9285.71

Budget balance = Government revenue - Government expenditure

Budget balance = [0.10 * Y] - 600

Budget balance = [0.10 * 9285.71] - 600

Budget balance = 928.571 - 600

Budget balance = 328.571

The government is running a budget surplus of $328.571

Graph for output.

In the above graph,

The initial aggregate expenditure is AE.

Initial equilibrium is at point E.

The initial equilibrium output is $8372.09.

As exports and imports become zero.

It shifts the aggregate expenditure curve downwards but it also makes the aggregate expenditure
curve steeper.

Thus new aggregate expenditure is AE*

The new equilibrium is at point E*

The new equilibrium output is $9285.71

Graph for budget balance.

The initial equilibrium output is $8372.09

Government spending is $600.

Government revenue is $837.209

The government budget surplus is $237.209

The new equilibrium output is $9285.71

Government spending is $600.

New Government revenue is $928.571

The New Government budget surplus is $328.571

4. It has been estimated that your potential GDP (𝑌𝑃) is approximately $12,000. Describe
the effects of your current equilibrium GDP and your potential GDP - what will happen in
your economy and why? What is our structural budget balance for this 𝑌𝑃?

The actual GDP is $9285.71

Potential GDP is $12000

As actual GDP is less than potential GDP, it means that the economy is experiencing a
recessionary output gap.

The economy is in a recession.

As actual GDP is less than potential GDP, the actual rate of unemployment would be more than
the natural rate of unemployment in the economy. Thus the economy is experiencing a higher
level of unemployment.

As unemployment is high, and income levels are low, it would result in lower spending on
consumer goods and services being done by the households would mean a lower level of
consumption and a lower level of standard of living.

Thus when actual GDP is less than potential GDP, households in the economy experience
decline in their standard of living.
The structural budget balance is budget balance when the economy is at its potential level.

Structural budget balance = Government revenues - Government expenditure

Structural budget balance = 0.10 * 12000 - 600

Structural budget balance = 1200 - 600

Structural budget balance = 600

Structural budget balance is $600

5. To reach your potential GDP, describe any changes you - as the government - would
make to either your tax rate or your government expenditure. Graph the changes you
describe and determine the effects on GDP, Government expenditure, taxation, and budget
balance.

As a government, I would increase government expenditure.

An increase in government expenditure results in a proportionally larger increase in aggregate

expenditure due to the government spending multiplier effect which results in an increase in
output thereby making actual output equal to potential output thus eliminating the recessionary
output gap.

Government spending multiplier = 1 / 1 - (MPC ( 1 - T))

Government spending multiplier = 1 / 1 - (0.80 (1 - 0.10))

Government spending multiplier = 1 / 1 - (0.80 (0.90)

Government spending multiplier = 1 / 1 - 0.72

Government spending multiplier = 1 / 0.28

Government spending multiplier = 3.5714

Recessionary output gap = Potential GDP - Actual GDP

Recessionary output gap = 12000 - 9285.71

Recessionary output gap = 2714.29

Thus, required increase in government spending = Recessionary output gap / Government

spending multiplier

Required increase in government spending = 2714.29 / 3.5714

Required increase in government spending = 760

Thus I would increase government spending by $760, which would result in an increase in output
by $2714.29 thereby making output equal to potential output thus eliminating the recessionary
output gap.

Taxation = 0.10 * Y

Taxation = 0.10 * 12000

Taxation = 1200

New level of tax revenues is $1200

Budget balance = Total government revenue - Total government spending

Budget balance = 1200 - (600 + 760)

Budget balance = 1200 - 1360

Budget balance = -160

The government is running a budget deficit of $160

GDP would increase by $2714.29

Government expenditure would increase by $760

The new level of tax revenues is $1200

The government is running a budget deficit of $160

References:

 Amadeo, K. (n.d.). Expansionary fiscal policy explained. The Balance. Retrieved January
21, 2022, from https://www.thebalance.com/expansionary-fiscal-policy-purpose-
examples-how-it-works-3305792
 (2016, June 17). 28.2 the aggregate expenditures model. Principles of Economics.
Retrieved March 5, 2022, from https://open.lib.umn.edu/principleseconomics/chapter/28-
2-the-aggregate-expenditures-model/