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Macro Economics - Essay Example

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The determination of the level of GDP (Gross Domestic Product) in the short run is determined by the model developed by John Maynard Keynes. This model works on the basic premise that the level of production in the economy depends upon the level of aggregate demand. …
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Macro Economics
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Download file to see previous pages (Sloman, 2006) Keynesians believe that if left to the market forces there is no guarantee that the economy will achieve a full employment level of GDP. They argue that instead when left on its own economy may not function as required and may result in high levels of unemployment. Therefore, to control this it is important for the government to intervene. If there is high unemployment the government should opt for deficit financing in order to increase the spending in the economy thereby, triggering economic growth. (Bamford et al. 2003) According to the circular flow of income national income should always be equal to the consumption of domestically produced goods and the withdrawals from the economy. Y= Cd + W Here National Income (Y) can be defined by the above equation. The withdrawals (W) are made up of net Savings (S), net Taxes (T) and spending on Imports (M). As we already know that the total spending in the economy on goods and services is known as Aggregate Expenditure (E). This is made up of the demand for locally produced goods plus the three injections (J): investment (I), government expenditure in the economy (G) and exports (X). (Sloman, 2006) When in equilibrium the Aggregate Expenditure is equal to National Income as injections are supposed to be equal to withdrawals. In the model put forward by the Keynesians in order to get equilibrium national income a line is drawn at 45 degrees. This is because at that point the Aggregate Expenditure will be equal to real GDP level of income. Thus, shown in the diagram below the level of income in the economy will be determined at the point where the AE curves interest the 45 degrees line. Figure 1 The Keynesian income-expenditure approach and aggregate demand and supply Diagram taken from Cliff Notes, 2011: Website Suppose that the economy is initially at the natural level of real GDP that corresponds to Y1 in Figure 1. Associated with this level of real GDP is an aggregate expenditure curve, AE1. Now, suppose that autonomous expenditure declines, from A1 to A3, causing the AE curve to shift downward from AE1 to AE3. This decline in autonomous expenditure is also represented by a reduction in aggregate demand from AD1 to AD2. At the same price level, P1, equilibrium real GDP has fallen from Y1 to Y3. However, the intersection of the SAS and AD2 curves is at the lower price level, P2, implying that the price level falls. The fall in the price level means that the aggregate expenditure curve will not fall all the way to AE3 but will instead fall only to AE2. Therefore, the new level of equilibrium real GDP is at Y2, which lies below the natural level, Y1. (Cliff notes, 2011) Question 2 “In economics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable. For example, suppose a one-unit change in some variable x causes another variable y to change by M units. Then the multiplier is M.” (Wikipedia, 2011) When the injections in an economy increases so does the amount of the national income (Y). The question here is by how much? In fact, national income Y will increase in a proportion more than the injections-J. Y will rise by a multiple of J. The number of times Y increases with respect to the change in the injections is known as the multiplier (k). Multiplier is equal to the change in national income Y divided by the change in injections. (Sloman, 2006) Apart from the above explanation above the value of the multiplier can also be determined by the following formula: K= 1/ (marginal propensity to withdraw). (Bamford et al. 2003) The four-sector economy is the most ...Download file to see next pagesRead More
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