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.

The Keynesian Consumption function expresses the level of consumer spending depending on three factors which relate as; C= a +b Yd, where

  1. Yd = disposable income which is the income after government intervention through avenues such as benefits and taxes)

  2. a = autonomous consumption this is consumption when income is zero.

  3. b = marginal propensity to consume this is the percentage of extra income that is spent. This is also referred to as induced consumption.

Therefore, this shows that consumption is primarily determined by the level of disposable income (Yd). Higher Yd, leads to higher consumer spending.

In this case C= $150+0.8Yd where $150 is the autonomous consumption, b is 0.8


Using y=mx +c

Where c=150 and m=0.8 we alternate the values of x and y to find the consumption function C= 150+0.8YD


International Economics

  1. The households begin to save at point A which is $750.

  2. Solution

Disposable income (x) on increase= 750+200= 950

Using y=m x +c where c=150, x=950, m=0.8

The new level of consumption will be 910 and the increase in consumption will be

910-750 = 160

This graph shows that as income rises, consumer spending will rise. However, consumption will increase at a lower rate than income. At low incomes, people tend to spend a high proportion of their income. The average propensity to consume could be one or greater than one. This means people spend everything they have. This is shown by the gradient of consumer function. Thus, when you have a lower income, you don’t have the luxury of being able to save since you need to spend everything you have on basics.

However, as incomes rise, people can afford the comfort of saving a higher percentage of their income. Therefore, as income rise, spending increases at a lower rate than disposable income. People with high incomes have a lower average tendency to spend.

  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)

The tax cut will result in workers realizing an increase in their discretionary income. In other words, the lowered tax will see workers keep more of their gross income and hence they will have more money to spend. This will result in their being better off and hence they will increase their spending which will result in a higher demand for goods and services thus leading to higher economic growth. Thus, the AD curve will shift as shown in the graph below. On the other hand, the supply side will also be positively affected. Owing to the increased demand, there will be greater output to satisfy the increased demand. In addition, there will be an increase in labor supply as more people will be willing to work at a lower tax rate since they will receive and keep more income. The increase in AS will however be less compared to the increase in AD. As such, the relatively increased AD will result in an increase in prices (p) as shown in the graph below. So in as much as there will be economic growth, prices will also increase at a faster rate resulting in inflation.

International Economics 1

  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).

The following are the steps that the government can take to stimulate economic growth;

  1. Effecting a cut on tax rate. As stated above, a cut in tax rate will result in a rise in both aggregate demand owing to the increased disposable income and hence increased consumption and hence aggregate demand. It will also result in increased output so as to satisfy the increased demand as well as the increased supply of labor since more people will be willing to work since the tax rate means they can receive and keep more income for which to spend. Thus, the GDP will increase from Yo to Y1 as shown in the graph below. It is however worth noting that a cut in taxes will only stimulate the economy if the economy is not in its full capacity as is the case during a recession.

International Economics 2

  1. Increase in government spending

Aggregate demand AD= C+I+G+(X-M) where G represents government spending. Thus by increasing its spending, the federal government will increase aggregate demand and hence stimulate the economy increasing the GDP as shown in the graph below. Government spending will increase such things as increase in infrastructure spending and transfer payments among others. If the government increases its spending by a certain percentage say 2%, the resultant improvement in GDP and hence the economy will be greater. This is because for instance when the government pays for a road construction, those employed by the contractor will use the income to buy other things from other sectors of the economy. This is known as the multiplier effect of the government spending and it effectively stimulates the economy. However, if the economy has achieved its full potential, increased government spending will not achieve the intended purpose since it is likely to crowd out private investment.

International Economics 3

  1. Expansionary monetary policy

The federal government could also use the central bank to effect expansionary monetary policy that will result in economic growth effectively stimulating the economy. One such a policy would be a cut on interest rates. This would make borrowing money cheaper and hence firms would invest more while households would consume more. Mortgage interests will also lower meaning households will also have more to spend either in investment or consumption. Since the interest rates are low, people would not be encouraged to save as they will not earn much from the savings. Thus, they will spend more. Thus, the overall effect of the expansionary monetary policy will be to increase aggregate demand resulting in economic growth as the economy will grow from Yo to Y1 as shown in the graph below.

International Economics 4

In this case, the GDP will increase from Y1 to Y2 as shown above.