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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.





Consumption function curve

The consumers will start to save when their disposable income will be above $500. This is at point A where the consumption curve meets the disposable income curve. Above this point of intersection, the consumption curve is below the disposable income curve, meaning that consumers spend less and now have excess of their disposable income to save. In other words, even though consumption increases, the marginal rate of propensity to consume declines.

The consumption at point A is $500. When income increases beyond point A by $200, the consumption increases by $210.

(15 marks)

  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 aggregate demand and aggregate supply are usually affected by the level of government expenditure and taxation policies. The federal government uses these tools of fiscal policies to regulate the economy during boom and recession periods of the country. Taxation provides both expansionary and contractionary effect to the AD and AS. To start with, when the government cuts on tax that is income tax of individuals, the disposable income of consumers tend to increase. An increase in disposable income will increase the consumers’ purchasing power, thus increase in demand for goods. Therefore, the multiplier effect of more disposable income is reflected in the marginal propensity to consume, so is a shift in aggregate demand. In addition to this, as tax reduces, the prices of commodities also reduce because of low production costs incurred in manufacturing, thereby increasing demand. On aggregate supply, a tax cut will reduce the prices charged by suppliers on their commodities because the amount of input tax is reduced. Due to this, suppliers will supply a lot into the market as they try to meet the demand resulting from reduced prices. However, suppliers cannot supply more than what they have, meaning that they must be able to produce as much as possible to meet the demand. In order to encourage production to meet demand, tax cuts especially income tax will motivate workers to increase their productivity. As a result, the economic output will generally increase. Therefore, with the inducement to work hard and increase production together with reduced prices on commodities will increase both aggregate demand and supply through tax cuts. However, this tax cut should be accompanied by increase in government expenditure in order to experience a complete shift of the AD and AS curves.

  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).

  1. Targeting Economy, Not Inflation

The first way in which the Federated Government stimulates the economy is focusing on the economy and not inflation. In essence, they are focusing on implementing policies that ensure that the annual inflation rate is maintained at 2%. Presently, the annual inflation rate stands at 1.7%. This substantially affects the investment behavior leading to the adverse effects of global economic growth. Adam states that one way of achieving the success that the Fed Government is focusing on enhancing the growth of gross domestic product a strategy popularly recognized as nominal GDP targeting (p1). This is the approach that ensures that the economic growth is kept at the sensibly path.

  1. Target Unemployment

The second approach utilized by the Fed Government targeting of unemployment. The Fed Government has initiated varies policies aimed at returning the economy back to full employment. In this case, they are working towards reducing the unemployment rate and enhancing maximum employment. One of the most effective ways of ensuring that full employment is achieved is that the Fed Government have gone an extra mile to accept a little inflation for some time. In addition to the above, they are creating more investment opportunities with the primary objective of increasing employment opportunities (Adam 1).

  1. Keeping Excess Interest Rates High

This is the third strategy that is utilized by the Federated Governments to stimulate the economy. Presently, the Fed Government pays private financial institutions 0.25% interest on deposited funds. These are the resources that are considered more than the required amount for prudential reasons. According to Adam in reality banks generate 0.14% by renting to low-risk businesses (p1). The primary objective of this strategy is to subsidize the profits of big banks and enhance the opportunity for banks to engage in the undesirable business of lending at high rates. This means that this policy compels the banks to lend more at lower interest rates. As a result, invest the borrowed money, create employment opportunities, and build the economy.

Work Cited

Adam, Hersh. Six Ways the Federal Reserve Could Boost the Economy. An Economist at the Center for American Progress Action Fund, and Cameron DE Hart, an intern at CAPAF, 2012