158 Assignment Solution: The Income-Expenditure Model

We start with an income-expenditure diagram with initial equilibrium at potential GDP, which the problem defines as $10,000 billion. Since export expenditures are a component of aggregate expenditures, a decrease in EX shifts the AE curve down by $100 billion. This cause a contraction in the economy.

Given the simple multiplier formula: 1/(1-MPC), the multiplier has a value here of 4; thus, the $100 billion decrease in spending causes GDP to fall by 4 x $100 = $400 billion or 4 percent. Using the formula for Okun’s Law given in the problem, the 4% decline in GDP will correspond to a 2 percentage point increase in the unemployment rate.