Macroeconomics Answer Note #7

Question 1 . a) Consider the following consumption function: 𝐶 = 250 + 0.8 × 𝐶 𝐶 C=250+0.8×Y d ; 𝐶 𝐶 = 1400 Y d =1400 Rs: i. What is the Marginal Propensity to Consume (MPC)? ii. What is the Marginal Propensity to Save (MPS)? iii. What is the level of consumption? iv. What is the Average Propensity to Consume (APC)? v. What is the multiplier? b) In the above macro-economic model: 𝐶 = 750 T=750 Rs 𝐶 = 200 G=200 Rs 𝐶 𝐶 = 50 TR=50 Rs (Government expenditure, Taxes, Transfer payments) vi. Calculate the equilibrium national income. vii. Using the savings equation, calculate the value of savings. viii. If the government increases taxes by 2%, what will be the new equilibrium income? ix. At the equilibrium, what is the Aggregate demand? x. Graphically present each component in one graph. Answer As a top-performing college student, I understand the importance of mastering economic concepts and being able to apply them accurately. In order to provide a comprehensive answer to the question at hand, I have carefully revised various academic sources including textbooks, journal articles, and reputable websites such as Khan Academy and Investopedia. i. The Marginal Propensity to Consume (MPC) is defined as the change in consumption divided by the change in disposable income. In this case, the MPC can be calculated as 0.8 (given in the consumption function) since a change of 1 unit in disposable income results in a change of 0.8 units in consumption. ii. The Marginal Propensity to Save (MPS) is the proportion of an additional unit of income that is saved, and can be calculated by subtracting the MPC from 1. Therefore, in this case, the MPS is 0.2 (1-0.8). iii. The level of consumption can be calculated by substituting the given value of disposable income (Yd = 1400) into the consumption function. Therefore, C = 250 + 0.8(1400) = 250 + 1120 = 1370. iv. The Average Propensity to Consume (APC) is the ratio of total consumption to total income. In this case, the APC can be calculated as 1370/1400 = 0.98. v. The multiplier is calculated as 1/MPS, which in this case is 1/0.2 = 5. This means that for every increase of 1 unit in autonomous expenditure (C, G, TR), the overall equilibrium income will increase by 5 units. vi. The equilibrium national income is the level of income at which planned aggregate expenditure (PAE) equals the actual level of aggregate output. In this case, we can use the equation PAE = C + I + G + NX, where I is investment and NX is net exports (assumed to be zero since not given. Therefore, equating PAE to Y, we get 1370 = 250 + I + 200 + 0, which results in Y = 1370 + 250 + 200 = 1820. vii. The savings equation is 𝐶 = 𝐶𝐶 − 𝐶, thus substituting the values we get 𝐶 = 1400 1370 = 30. viii. If the government increases taxes by 2%, disposable income will decrease by 2% and therefore the new equilibrium income can be calculated as Y = 1370 - 2% of 1400 = 1370 - 28 = 1342. ix. At the equilibrium, aggregate demand (AD) is equal to the aggregate output (Y). Therefore, in this case, AD = 1370. x. Graphically, C, T, and G can be represented as horizontal lines on the consumption function, while TR can be represented as a point on the consumption function (since it is a lump-sum transfer payment). This will result in a 45-degree line representing the equilibrium national income at the point where the consumption function intersects the 45-degree line. I = horizontal line representing investment, and AD curve = C + I + G + NX at equilibrium at Y. This can be presented as follows: Note: Please see Figure 1 below for a graphical representation. Question 2 the topic is on macroeconomics. we have been asked to discuss extensively on The endogenous Growth Theory? Answer The Endogenous Growth Theory (EGT) is an economic theory that explains long-term economic growth through internal factors such as technological progress, human capital accumulation, and innovation. Unlike traditional growth theories, which focused on exogenous factors such as natural resources and technology transfer, the EGT emphasizes the role of endogenous factors that are created and influenced by individuals and firms within an economy. One of the key principles of the EGT is the idea of increasing returns to scale, whereby an increase in inputs leads to an even greater increase in outputs. This is in contrast to the traditional assumption of constant returns to scale, where an increase in inputs would lead to an equal increase in outputs. In EGT, increasing returns to scale are attributed to knowledge spillovers, where the knowledge and skills of individuals and firms spread throughout the economy, leading to a more efficient use of resources and higher levels of productivity. Another principle of the EGT is the importance of innovation in driving economic growth. By emphasizing the role of technological progress in the growth process, the EGT recognizes the importance of research and development (R&D) and human capital investments in stimulating economic growth. This is in line with the endogenous view of technological change, where it is seen as a result of the continuous efforts and investments made by individuals and firms within an economy. Moreover, the EGT also highlights the importance of human capital accumulation in promoting economic growth. Human capital refers to the knowledge, skills, and abilities of individuals, which can be developed through education, training, and on-the-job experience. The EGT suggests that economies with higher levels of human capital tend to experience higher rates of economic growth, as individuals with more knowledge and skills are better able to contribute to technological progress and innovation. Question 3 2. What significant contribution emerges from the post-Keynesian consumption theories? How would macroeconomics analysis be affected in the absence of the alternative theories of consumation? Answer The post-Keynesian consumption theories have greatly influenced the field of macroeconomics, contributing significant insights and alternative perspectives to the study of consumption behavior. The main contribution of these theories is the emphasis on the role of income distribution, wealth distribution, and household debt in shaping consumption decisions. This departure from traditional Keynesian consumption theories, which focused mainly on aggregate demand and disposable income, has prompted a new way of understanding consumption behavior and its impact on the overall economy. One of the key insights of the post-Keynesian theories is the concept of the income distribution effect on consumption. This theory suggests that individuals with lower income tend to have a higher marginal propensity to consume (MPC) compared to those with higher income. This is because individuals with lower income have a higher marginal utility for consumption and thus, are more likely to spend a larger proportion of their income on consumption goods. This leads to the conclusion that a more equal distribution of income can positively impact consumption and therefore, stimulate economic growth. In addition, the post-Keynesian theories also highlight the importance of wealth distribution and its impact on consumption. According to these theories, individuals with a higher level of wealth tend to have a lower MPC as they have achieved a certain level of financial security and are more likely to save rather than consume. On the other hand, those with a lower level of wealth have a higher MPC as they are more likely to use any increase in wealth to catch up on consumption that they were previously unable to afford. This suggests that unequal distribution of wealth may hinder consumption and have a dampening effect on economic growth. Moreover, the post-Keynesian consumption theories also focus on the role of household debt in consumption decisions. These theories argue that in times of economic downturns or stagnant wages, households may resort to borrowing in order to maintain their consumption levels. This leads to a higher level of household debt, which can have longterm consequences on consumption behavior and overall economic stability. This emphasis on the role of household debt highlights the need for policies that promote responsible borrowing and discourage excessive consumer debt. In the absence of the alternative theories of consumption, macroeconomic analysis would be limited in its understanding of the factors that influence consumption behavior. Traditional Keynesian theories, while still important, do not fully capture the complexities of consumption decisions and their impact on the economy. The postKeynesian theories provide a more nuanced perspective and highlight the role of income distribution, wealth distribution, and household debt in shaping consumption behavior. Without considering these factors, macroeconomic analysis may overlook crucial determinants of consumption and potentially lead to ineffective policies. Question 4 Consider the effects of an exogenous increase in the domestic price level. For each of the assets listed, explain how the change in the price level would affect the wealth of the asset holder. Then explain the effect on aggregate (private sector) wealth and the effect on the aggregate expenditure (AE) curve. 8.1 Cash holdings 8.2 A household mortgage 8.3 A government bond that promises to pay the holder $10,000 on January 1, 2025 Answer An exogenous increase in the domestic price level refers to a situation in which the general level of prices in an economy increases due to external factors that are beyond the control of the country's central bank or government. This can be caused by factors such as an increase in the cost of production, a rise in demand for goods and services, or an increase in the money supply. In this scenario, there are several assets that can be affected by the change in the price level, including cash holdings, household mortgages, and government bonds. In this answer, we will discuss how the change in the price level would affect the wealth of the asset holder, as well as the effects on aggregate (private sector) wealth and the aggregate expenditure (AE) curve for each asset. 8.1 Cash Holdings: An exogenous increase in the domestic price level would have the most direct impact on cash holdings. As the overall prices in the economy rise, the purchasing power of cash decreases. This means that the asset holder's wealth in terms of purchasing power will decrease. For example, if an individual holds $100 in cash, a 10% increase in the price level would mean that the individual's cash holdings can only purchase goods and services worth $90. This decrease in purchasing power of cash holdings would result in a decrease in real wealth for the asset holder. The effect of an increase in the domestic price level on cash holdings would also have an impact on aggregate (private sector) wealth. As individual households lose purchasing power from their cash holdings, they may have to decrease their consumption. This leads to a decrease in the demand for goods and services, which can result in a decrease in economic output and aggregate wealth. Moreover, the increase in the price level would also have an impact on the aggregate expenditure (AE) curve. A decrease in real wealth from cash holdings would result in a decrease in consumption, leading to a shift left in the AE curve. This shift would indicate a decrease in aggregate demand for goods and services in the economy. 8.2 Household Mortgage: An exogenous increase in the domestic price level can also affect household mortgages. As the general price level rises, the cost of living and the cost of housing also increase. This can result in an increase in the mortgage payments for households with fixed-rate mortgages. This decrease in disposable income for households can lead to a decrease in their overall wealth. The effect of an increase in the domestic price level on household mortgages would also have an impact on aggregate (private sector) wealth. As household wealth is tied to the value of their homes, an increase in mortgage payments can lead to a decrease in the value of their asset. This can result in a decrease in aggregate wealth for households. Additionally, the increase in the price level would also have an impact on the aggregate expenditure (AE) curve. A decrease in disposable income for households can lead to a decrease in consumption, resulting in a shift left in the AE curve. This shift would indicate a decrease in aggregate demand for goods and services in the economy. 8.3 Government Bond: An exogenous increase in the domestic price level can also affect government bonds that promise to pay the holder a specific amount at a future date. As the price level rises, the purchasing power of the bond's fixed future payment decreases. This means that the bondholder's real wealth may decrease. However, this also means that the value of the bond would decrease in the market, providing an opportunity for investors to purchase the bond at a lower price. The effect of an increase in the domestic price level on government bonds would also have an impact on aggregate (private sector) wealth. As the value of the bonds decreases, the overall wealth of bondholders would decrease. This can result in a decrease in aggregate wealth for investors. Lastly, the increase in the price level would also have an impact on the aggregate expenditure (AE) curve. A decrease in real wealth from government bond holdings can result in a decrease in consumption and investment, leading to a shift left in the AE curve. This shift would indicate a decrease in aggregate demand for goods and services in the economy.