MACRO-ECONOMICS assignment 5

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Published on March 7, 2014

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MACRO-ECONOMICS
Consider a closed economy to which the Keynesian-cross analysis applies. Consumption is given by the equation C = 100 + 2/3(Y – T), where Y represents income and T represents taxes. Planned investment is 300, as are government spending and taxes.
According to the statement above;
C = 100 + 2/3(Y – T)
Planned investment = I = 300
Govt. spending = G = 300
Taxes = T = 300

UNIVERSITY OF MANAGEMENT AND TECHNOLOGY ASSIGNMENT - 5 SUBMITTED TO: MS. AFIA MUSHTAQ Bilal Ahmad 12002001006 Sajid Nadeem 12002001004 M. Aqeel Butt 12002001009 Basir Khan 12002001010 2013 MACRO-ECONOMICS

Q: 1 briefly explains the following with examples. Planned Investment Investment expenditures that the business sector intends to undertake based on expected economic conditions, interest rates, sales, and profitability. The difference between planned and actual investment is unplanned investment, which is inventory changes caused by a difference between aggregate expenditures and aggregate output. If actual and planned investments differ, then aggregate expenditures are not equal to aggregate output, and the macro economy is not in equilibrium.1 Automatic stabilizers They are the federal governments or receipts that automatically increase without any action by the government. They work as a tool to dampen fluctuations in real GDP for example taxes, transfers, and purchases are automatic stabilizers of the economy.2 This not only provides support for struggling citizens, but also gets money to people very likely to spend it, which boosts demand as the economy weakens. When incomes are high, tax liabilities rise and eligibility for government benefits falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax liabilities drop and more families become eligible for government transfer programs, such as food stamps and unemployment insurance that help support their income.3 Automatic stabilizers are so called because they act to stabilize economic cycles and are automatically triggered without explicit government intervention. Example: In a progressive taxation structure, the share of taxes in national income falls when the economy is booming and rises when the economy is in a slump. This has the effect of cushioning the economy from changes in the business cycle. Crowding out effect A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect. For Example: crowding out occurs is government financing of projects with deficit spending through the use of borrowed money. Because the government borrows such large amounts of capital, its activities can increase interest rates. Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investment activities. 1 http://glossary.econguru.com/economic-term/planned+investment http://www.ask.com/question/what-are-automatic-stabilizers 3 http://www.taxpolicycenter.org/briefing-book/background/stimulus/stabilizers.cfm 2 MACRO-ECONOMICS Page 2

Aggregate Expenditures Aggregate expenditures are the total expenditures on gross domestic product. These expenditures are used by the household, business, government, and foreign sectors to purchase the entire gross domestic product supplied by the domestic economy. These combined expenditures are a key part of the foundation of macroeconomic analysis or unemployment, inflation, business cycles, and other phenomena.4 The equation is: AE = C + I + G + NX Q 2: Consider a closed economy to which the Keynesian-cross analysis applies. Consumption is given by the equation C = 100 + 2/3(Y – T), where Y represents income and T represents taxes. Planned investment is 300, as are government spending and taxes. According to the statement above; C = 100 + 2/3(Y – T) Planned investment = I = 300 Govt. spending = G = 300 Taxes = T = 300 A. If Y is 1,500, what are planned aggregate expenditures? What is inventory accumulation orde-accumulation? Should equilibrium Y be higher or lower than 1,500? Hint; planned expenditure=Y, and inventory =Y-planned expenditure If Y is 1500 then Planned Aggregate Expenditure = E = C+I+G = 100+ 0.66667(Y-T)+300+300 = 700 + 0.66667(1500-300) =700+ 0.66667(1200) =700+800 =1500 So when Y=1500, Planned Aggregate Expenditure is 1500. 4 http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=aggregate+expenditures MACRO-ECONOMICS Page 3

Y=1500, and Planned Aggregate Expenditure is also 1500 i.e. both are equal (Y – Planned expenditure = 1500 - 1500 = 0) which is an ideal situation because if aggregate output (income) (Y) is not equal to planned aggregate expenditure, firms will react until equilibrium is achieved. 1. When planned aggregate expenditure exceeds aggregate output (income), unplanned inventory reductions occur, and firms react by increasing output. 2. When planned aggregate expenditure is less than aggregate output (income), unplanned inventory increases occur, and firms react by decreasing output. As Y=1500 and planned aggregate expenditure is also 1500, so we do not need to change the output (Y). B. What is the planned expenditure function? What is equilibrium level of income? Show your results in a diagram clearly indicating the intercepts and equilibrium values. The planned expenditure function, E = C+I+G =100 +2/3(Y-T) +300+300 = 700 + 2/3(Y-300) = 700 +2/3Y -200 = 500 + 2/3Y So, the planned expenditure function is 500+2/3Y i.e. E = 500+2/3Y If Y is 0, E = 500. So, the vertical intercept (E-intercept) of the expenditure function is 500. The equilibrium condition: Y=E Or, Y = 500 +2/3Y Or, Y-2/3Y = 500 Or, Y (1-2/3) Y = 500 Or, 1/3Y = 500 Or, Y = 1500 So, equilibrium level of income is 1500. MACRO-ECONOMICS Page 4

C. What are equilibrium consumption, private saving, public saving, and national saving? Hint: private saving=Y-C-T Public saving=T-G Equilibrium saving=Y-C-T The equilibrium consumption, C = 100 + 2/3(Y-T) = 100 + 2/3 (1500-300) = 100 + 2/3(1200) = 900 So, the equilibrium consumption is 900. The equilibrium private saving, SP = Y-C-T = 1500-900-300 = 300 So, the equilibrium private saving is 300. The equilibrium public saving, SG = T-G = 300–300 =0 MACRO-ECONOMICS Page 5

So, the equilibrium public saving is 0. The equilibrium national saving, S= Y-C-T = 1500-900-300 = 300 So, the equilibrium national saving is 300. d. How much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending? We know; Y=C+I+G Where C = 900 So Y = 900 + 300 + 200 Y= 1400 As C = 100 + 2/3(Y-T) So MPC = 2/3 =0.66667 The government spending multiplier = 1/(1-MPC) = 1/(1-2/3) = 1/(1/3) =3 MACRO-ECONOMICS Page 6

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