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Question 1

International Economics

Figure 1: Consumption functions

The red line in figure 1 above shows the consumption function, C = 150 + 0.8YD. According to this line, the autonomous value of $150 indicates that the will still consume $150 at the point when their disposable income, YD is zero. However, at the point when the disposable income is $100 per year, then the consumption becomes C = $150 + 0.8*$100. This total to C = $230. The households starts saving at the point where the red line intersects with the blue line at Point A.

An increase in the level of disposable income will result in an increase in the consumption. However, such an increase will only be proportional to the marginal propensity to consume. For example, an increase of $200 in the income from point A will result in a new income of $1100. Consequently, this will cause an increase in the consumption to point B by $130. A smaller marginal increase in the consumption implies a greater increase in income hence a marginal propensity to save (MPS).

Question 2:

Fiscal policy refers to the policy of governments that tries to impact on the state of a country’s economy via its proposed changes in tax levels or spending. Monetary policy on the other hand aids the government through its central bank to control the supply of money in the economy. This helps to control the rate of inflation from skyrocketing in the country.

Aggregate demand involves the overall consumption, government, pending, net exports and investment. This means that incase of any changes on the above macroeconomic components, Aggregate Demand curve (AD) will automatically shift. Aggregate Supply (AS) on the other hand refers to the overall output that the economy produces at a certain period of time using a certain price level. Any given change in AD will result in distinct price level changes (Schnabl, 2015). Governments often try to impact on the state of economy through taxes or spending adjustment. Any adjustment on either of the two components will either increase or decrease the AD.

Tax cuts are applied by the governments mostly during the recessions to stimulate the economy of the country to take off. The figure below shows explicitly how cut in taxes level is likely to impact on both AD and AS. There will be a shift of AD curve to the right, which prompts AS curve too to shift to the same direction. However, the shift in AS is less than the shift in AD. The reduction in the taxes levels acts as an incentive to work and earn more income. This is why AD curve shifts to the right from AD to AD1. The shift in AS is less than the shift in AD because the incentive to work brought about by tax cut is very minimal. Prior to these changes in the taxes level, point E in the figure below acts as the economic equilibrium, Y0 represents the output while P0 is the price level. However, in short run after effecting tax level reduction, AD curve will move to AD1. At Po the new equilibrium will be E1 and new output will be a whopping Y2. At this point in time, the total tax revenue of the country will fall by an amount less than the tax level cut.

However, in the long run, the economy’s equilibrium changes from E1 to E2. The increase in GDP from Y0 to Y1 is less than the increase in GDP in Y0 to Y2. This could be due to the fall in government’s tax collection which leads to budget deficit. Similarly, the increase in AD is much more than the increase in AS and this is why there will be an increase in price levels at long run from Po to P1

International Economics 1

International Economics 2Figure 2: effects of tax cut on AS and AD

Question 3:

Persistent economic shocks across the globe, coerced economists to start questioning the workability of pre-Keynesian economic policies. Keynesian alongside his followers urged the need for government tinkering in the economy to ensure that economic equilibrium is always maintained at all times. Proponents of Keynesian economic theory cast aspersion on the effectiveness of the economy that is purely controlled by private sector. They instead propose greater government involvement in the balancing of the economy through monetary policy spearheaded by respective government central banks and the fiscal policy. Federated government uses these economic policies to resuscitate the economy from say recession. This can be done through increasing government spending, lowering the interest rates and cut down on the tax levels in the country.

Increased government spending

International Economics 3

Figure 3: impact of expansion policy by federal’s fiscal policy


The figure above shows how increased government spending changes the country’s real GDP from Y1 to Y2. This is occasioned by the fact that increased government spending in infrastructure development, providing social amenities among others stimulated the in aggregate demand from AD to AD1 as shown in the above figure. Government spending also widens the employment opportunities in the country. This ensures that majority of the country’s citizens have adequate disposable income to spend back in the economy. In the long run, this behavior uplifts the economy from the recession.

Reduction in tax level

International Economics 4

Figure 4: effects of tax cut on AS and AD

The government may opt to stimulate the economy adjusting its tax policy. A reduction in tax levels has a positive effect on both AS and AD as shown on the figure above. AD curve shifts to the right from AD to AD1. This shift also influences AS to shift from AS to AS1. Ultimately, these shifts has a direct impact on the output levels. In the short run, output level moves from Y0 to Y2 representing a significant improvement in the economy. However, this changes in the long run to Y1. Tax cut enables people to have more disposable income to spend in the economy through purchases of goods and services. However, tax cut can also reduce the governments’ tax revenues. This is likely to bring about budget deficit in the long run.

Reduction of interest rates levels.

Federated governments can also stimulate the economy via reduction of interest rates in the economy through the monetary policy. Interest rates forms an important economic component whose adjustment has a direct impact on the overall economy of the country. It is often used to control inflation rates in the economy and also stimulate the economic growth of the country. Reduction of interest rates during recession, spurs up household expenditure as they have more disposable income to spend. This ultimately uplifts the economy of the country from recession in the short run. However, this has to be properly monitored to avert chances of this increased spending by households degenerating into inflation in the long run. Schnabl (2015) argues that lower interest rates brings down the cost of borrowing in the country. This encourages households to borrow more funds and increase spending. However, this reduces saving incentives in the economy.

International Economics 5

Figure 5: monetary expansion policy-reduction of interest rates

The above figure shows that when interest rates are higher say r1 the quantity of disposable income available to households to spend is less say Qm1, however, this is likely to change if the government opts to reduce the interest rates from r1 to r2. Quantity of money in the hands of individual households increases from Qm1 to Qm2. This available disposable income acts as incentive to spend more in the economy in order to uplift it from economic oblivion.


Schnabl, G. (2015). Monetary Policy and Structural Decline: Lessons from Japan for the European Crisis. Asian Economic Papers, 14(1), 124-150.