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Chapter 11: Q2. (page 236)

Why does equilibrium real GDP occur where C + Ig = GDP in a private closed economy? What happens to real GDP when C + Ig exceeds GDP? When C + Ig is less than GDP? What two expenditure components of real GDP are purposely excluded in a private closed economy?

Short Answer

Expert verified

Equilibrium real GDP equals the total spending in the economy to avoid the problem of overproduction and underproduction.

When total spending exceeds real GDP, firms increase their production to cover the gap.

When total spending is less than real GDP, firms cut down their production to minimize the gap.

Government expenditure and net exports are purposely excluded in a private closed economy.

Step by step solution

01

Step 1. Reason for equilibrium real GDP at C + Ig = GDP

Real GDP is the output produced in an economy, while consumption and gross investment are the private closed economy's total spending (or the income generated from the output).

Equilibrium real GDP is the income generated from the output produced in the economy and is just sufficient to purchase the output. The equilibrium real GDP occurs at C + Ig = GDP to avoid overproduction or underproduction in the economy.

If GDP > C + Ig' it will result in the problem of overproduction. If GDP < C + Ig' it will lead to underproduction in the economy. At these points, the economy is not stable, and there is pressure on prices which affects the demand and supply.

02

Step 2. Total spending exceeds GDP

When total spending exceeds the production in the economy, the output is consumed faster than it is produced and planned inventories fall short.

The firms can balance the gap between spending and output by increasing production. The increased production will match the demand, and there will be no price pressure that can result in an unstable situation.

03

Step 3. Total spending is less than GDP

Where real GDP exceeds C + Ig' lower total spending implies that there is not sufficient capacity in the economy to purchase the output, and the firms' unplanned inventories increase.

To minimize unplanned inventories, the firms will have to cut down production. Thus, the total spending and income of the economy are reduced to restore the economy's equilibrium.

04

Step 4. Excluded expenditure components in a private closed economy

In determining the equilibrium of a private closed economy, government expenditure and net exports are purposely excluded. Government expenditure does not produce any output, it only multiplies the total spending. Also, consumption and investment expenditure are generated from the private sector, and there is no role of the public sector in it.

Net exports include foreign economies in the production and consumption, which drains the domestic income and brings some foreign income in return.The interaction with the foreign economies makes it an open economy model.

Therefore, to study the private and closed economy exclusively, government expenditure and net exports are excluded.

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Most popular questions from this chapter

Assuming the economy is operating below its potential output, how does an increase in net exports affect real GDP? Why is it difficult, perhaps even impossible, for a country to boost its net exports by increasing its tariffs during a global recession?

The data in columns 1 and 2 in the table below are for a private closed economy.

  1. Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy.

  2. Now open up this economy to international trade by including the export and import figures of columns 3 and 4. Fill in columns 5 and 6 and determine the equilibrium GDP for the open economy. What is the change in equilibrium GDP caused by the addition of net exports?

  3. Given the original \(20 billion level of exports, what would be net exports and the equilibrium GDP if imports were \)10 billion greater at each level of GDP?

  4. What is the multiplier in this example?

(1) Real Domestic Output (GDP = DI), Billions

(2) Aggregate Expenditures, Private Closed Economy, Billions

(3) Exports, Billions

(4) Imports, Billions

(5) Net Exports, Billions

(6) Aggregate Expenditures, Private Open Economy, Billions

\(200

\)240

\(20

\)30



250

280

20

30



300

320

20

30



350

360

20

30



400

400

20

30



450

440

20

30



500

480

20

30



550

520

20

30

Refer to the accompanying table in answering the questions that follow:

(1) Possible Levels of Employment, Millions

(2) Real Domestic Output, Millions

(3) Aggregate Expenditures (Ca + Ig+ Xn+ G), Millions

90

\(500

\)520

100

550

560

110

600

600

120

650

640

130

700

680

  1. If full employment in this economy is 130 million, will there be an inflationary expenditure gap or a recessionary expenditure gap? What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary expenditure gap or the recessionary expenditure gap? What is the multiplier in this example?

  2. Will there be an inflationary expenditure gap or a recessionary expenditure gap if the full employment level of output is $500 billion? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the gap? What is the multiplier in this example?

  3. Assuming that investment, net exports, and government expenditures do not change with changes in real GDP, what are the values of the MPC, the MPS, and the multiplier?

A depression abroad will tend to _______ our exports, which in turn will _______ net exports, which in turn will ______ equilibrium real GDP.

  1. reduce; reduce; reduce

  2. increase; increase; increase

  3. reduce; increase; increase

  4. increase; reduce; reduce

Question: If an economy has an inflationary expenditure gap, the government could attempt to bring the economy back toward the full-employment level of GDP by _______ taxes or _______ government expenditures.

  1. increasing; increasing

  2. increasing; decreasing

  3. decreasing; increasing

  4. decreasing; decreasing
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