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ECU22012

Intermediate Economics B

Problem Set 1

1. In the short run, it is assumed that demand determines output. Explain the basis

for this assumption.

In the short term there will be price stickiness and a tendency for prices not to

move easily; there is also the expression 'opinion determines demand'. Also

because short-run equilibrium national income is determined by effective demand,

while long-run is determined by the level of supply

Z = C + I + G

C = 500 + 0.5YD

YD = Y − T

T = 600

I = 300

G = 600

a) Given the above variables, calculate the equilibrium level of output. Hint: First specify (using the above numbers) the demand equation (Z) for this economy. Second, using the equilibrium condition, equate this expression with Y. Once you have done this, solve for the equilibrium level of output. Using the ZZ-Y graph (i.e., a graph that includes the ZZ line and 45-degree line with Z on the vertical axis, and Y on the horizontal axis), illustrate the equilibrium level of output for this economy.

b) Now, assume that consumer conﬁdence decreases causing a reduction in au- tonomous consumption (c0 ) from 500 to 400. What is the new equilibrium level of output? How much does income change as a result of this event? What is the multiplier for this economy?

c) Graphically illustrate the eﬀects of this change in autonomous consumption on the demand line (ZZ) and Y. Clearly indicate in your graph the initial and ﬁnal equilibrium levels of output.

d) Brieﬂy explain why this reduction in output is greater than (in absolute terms) the initial reduction in autonomous consumption.

3. Suppose that the government increases government spending and taxes by the same amount (a balanced- budget ﬁscal expansion). Using the same values as in question

(2), explain the impact on output of raising G and T each by 100.

4. Use the ZZ-Y model to illustrate the eﬀects of a reduction in consumer conﬁdence on the economy. Also, explain what eﬀect this reduction in consumer conﬁdence

has on the economy.

Falling consumer confidence could cause inflation. And the economy will grow at a ouepsopsctehe United States economy is represented by the following equations: