International economics Essay Example

Assessment 1:

Note: This is an individual assessment. Please provide a neat diagram to explain your answer in each question. You are required to answer each question as follows:

  1. Give an introduction to the question and explain all key terms

  2. Give a graft, label the axes properly and identify all the curves

  3. Give a brief description of the changes and outcomes as indicated by the graft.

The maximum possible marks to be awarded to you are 40 marks.

Maximum marks: 40 marks

  1. On the graft below, draw the consumption function C=$150+0.8YD.

Consumption is $billions per year.

Disposable income is $100 billion per year.

Answer the following questions:

  • At what level of income do households begin to save? Indicate the point on the graph with the letter A.

  • By how much does consumption increase when income rises $200 beyond point A? Indicate this new level of consumption with point B.

C= $150+0.8YD

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(15 marks) A B

  1. At point A shown on the graph, both disposable income and consumption are equal at $750 billion. This is the point beyond which the households begin to save.

  2. At point B shown in the graph, the disposable income is $950 billion or $200 billion beyond point A. At this point, households’ consumption is at $910 billion. Thus, an increase of $200 billion income resulted in a $160 billion increase in consumption.

  1. Fiscal and monetary tools are used to fix the macro economy. Briefly explain how might a tax cut affect both AD and AS? (10 marks)

A tax cut is likely to affect both the aggregate demand and aggregate supply. However, the overall effect of a tax cut is an increase in aggregate supply by a large margin which will eventually lead to an increase in tax collection.

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From the graph above, it is clear that a cut in tax rate will cause the aggregate demand curve to shift to D1. This is caused by the increased disposable income for the consumers and hence increased consumption which increases demand. Similarly, the aggregate supply curve will shift to S1 because of the increased output as well as the increased supply of labor since more will be willing to work due to the lowered taxes. However, the shift in aggregate demand will be greater than the shift in aggregate supply. This results from the fact that although the decrease in tax rate increases the incentive to work, the effect of such an incentive will be very small meaning that the shift in aggregate supply will be very small.

Before the tax cut, the economic equilibrium is at E, the price level is at Po while the output will be Yo. In the short run, the aggregate demand is affected with AD curve shifting to AD1 at price Po with the equilibrium shifting to E1. On the other hand, the output greatly increases to Y2. This means that the total tax amount will fall by a lesser amount than the tax rate cut. This is the AD effect. However in the long run, the economy is at E2 and the GDP will increase though by a lesser amount YoY1<YOY2. Thus, the overall effect will be a fall in tax collections with the deficit increasing since the government revenue did not increase by a large amount as the GDP increase was small. It is worth noting that tax collections are dependent on the level of income. However, the tax cut only resulted in a small increase in GDP and hence income. Thus, the tax collection will only increase by a lesser amount. On the other hand, the increase in aggregate demand was greater than the increase in aggregate supply this means that prices will increase to P1.

  1. One of the goals of a Federated Government is to stimulate the economy. This may be achieved in three distinct steps. You are required to use 3 different grafts to indicate these three steps. (15 marks).

In order to stimulate economic growth, the federal government can use either demand side or supply side expansionary measures. These includes;

  1. Lowering income taxes-As stated above, lowering income tax will increase incentive to work and hence it increases the labor supply. In other words, if the income taxes imposed by the government are too high, the government can encourage people to work more by cutting them. This would lead to increased output and hence supply. Furthermore, the reduced taxes mean increased disposable income and hence an increase in consumption thus boosting demand. Thus, a tax cut will shift both the AD and AS which would eventually lead to an increase in GDP effectively stimulating the economy.

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  1. Increasing government spending

If the economy is not in full employment, increasing government spending will result in economic stimulation and hence an increase in GDP. Increasing government spending creates a multiplier effect. This is because the increased spending may cause the unemployed to gain jobs and hence they will have more disposable income and thus they will increase consumption. The increased consumption will lead to increased aggregate demand. For instance, those employed to construct roads would have salaries to spend in transport, entertainment etc. and hence other economic sectors in the economy will benefit from increased government spending. Thus, if the economy has a spare capacity, increased government spending will result in a bigger final increase in the GDP than the actual injection into the economy by the government through increased spending. This is shown in the graph below;

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Thus, increasing government spending will increase AD causing a bigger percentage increase in real GDP and smaller increase in price level if the economy has a spare capacity. This is economic stimulation.

  1. Lowering interest rates

In a bid to stimulate the economy, the federal government should lower the interest rates. The lower interest rates would make it cheaper to borrow thus encouraging spending and investment. This would lead to higher aggregate demand and hence economic growth which would effectively resulted in economic stimulation.

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