ECMA06 Tutorial #3 Answer Key
Question 1
Part (a)
• The AE function:
AE = C + I
AE = [60 + 0.75Y] + [100 – 10(r – 0.05)] = [60 + 0.75Y] + [100 – 10(0.05 – 0.05)]
AE = 160 + 0.75Y
• Equilibrium output/income:
In equilibrium, Y = AE:
Y = 160 + 0.75Y
0.25Y = 160
Y* = 640
Part (b)
Suppose that output is set accidentally at 600 (i.e., Y = 600):
• The level of AE when Y = 600:
AE = 160 + 0.75(600) = 610
Mechanism that brings output back to equilibrium:
• Since Y = 600 & AE = 610, the economy is trying to purchase more output than is being
produce; i.e., we have excess demand.
• Prices are fixed (by assumption) at their current level, firms try to satisfy the excess demand
by depleting their inventories that leaves inventories below their desired levels.
• To replenish inventories to their desired levels, firms would increase their current level of
output.
• This pressure will continue until output increases to its equilibrium level of 640.
If Y = 600, how will GDP be measured using the final products approach?
• If Y = 600, C = 60 + 0.75(600) = 510 & I = 100
• In terms of GDP accounting, C = 510 & investment = 600 – 510 = 90.
• Note: Investment = 90 because investment includes both I (= 100), which is intended
investment, and changes in inventories, which is – 10 (90 – 100).
Part (c)
Suppose that output is set accidentally at 700 (i.e., Y = 700):
• The level of AE when Y = 700:
AE = 160 + 0.75(700) = 685
Mechanism that brings output back to equilibrium:
• Since Y = 700 & AE = 685, the economy is producing more output than can be sold; i.e., we
have excess supply.
• Prices are fixed (by assumption) at their current level, firms find that their inventories pile up
unexpectedly, as they are producing more than they are selling.
ECMA06 Tutorial #3 Answer Key 1 • To lower inventories to their desired levels, firms would decrease their current level of
output.
• This pressure will continue until output decreases to its equilibrium level of 640.
If Y = 600, how will GDP be measured using the final products approach?
• If Y = 600, C = 60 + 0.75(700) = 585 & I = 100
• In terms of GDP accounting, C = 585 & investment = 700 – 585 = 115.
• Note: Investment = 115 because investment includes both I (=100), which is intended
investment, and changes in inventories, which is 15 (115 – 100).
Part (d)
dY
• The multiplier, :
dI
In equilibrium: Y = AE = 60 + 0

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