Economics: Principles & Applications - Assignment Example

Institution : xxxxxxxxxxx Title : xxxxxxxxxxx Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2012 Question one Consumption function is a function that shows the relationship between income and consumer expenditure. In this function, consumer expenditure is assumed to be directly proportional to disposable income, that is, an increase in disposable income results to an increase in consumer spending. Therefore, the consumer function expresses the level of consumer spending and has three determinants, which are: Disposable income (Yd) Autonomous consumption (a) Marginal propensity to consume (c) Disposable income refers to amount of money a person has to spend after the deduction of income tax. Autonomous consumption on the other hand refers to the consumption level that does not rely on income. It is what a person consumes when he or she earns zero income. It is believed that even with no income a person has to survive either through borrowing or running down savings. Marginal propensity to consume is the change in consumer expenditure brought about by a change in disposable income (Hall, & Lieberman, 2009). Mathematically, marginal propensity to consume is expressed as a derivative of consumption function with respect to disposable income that is, dC/dY. By incorporating all the three determinants, the standard consumption function is written as C = a+c (Yd) Therefore, the consumption function is a positive line graph that slopes upwards. The diagram below shows a simplified consumption function. The consumption model is basically determined by the level of disposable income. As shown in the above diagram, the higher the disposable income the higher the consumer spending. According to this model, an increase in income results to an increase in consumer spending. However, the rate at which consumer spending increases is lower than that of income. It is believed that at low income, consumers will spend a huge amount of their income. The average propensity to consume in this case can be either one or greater than one. This implies that consumers spend their entire income. People with low income do not have luxury of saving. They normally spend their entire income on essentials. However, when income increases, people are always able to enjoy the luxury of saving a huge amount of their income. Therefore, as income increases consumer spending increases. However, the increase in consumer spending will be at a lower rate than disposable income. Individuals earning high incomes have lower average propensity to spend. In case of a tax reduction, the low income earners will have high marginal propensity to consume the additional income. Spending will be greatly enhanced. High income earners on the other hand will have lower marginal propensity to consume. The benefit they obtain from tax cut will be directed in enhancing their savings. The diagrams below show the effects of change in consumer spending on consumption function In the above diagram, the consumption function has moved from C1 to C2. This implies that the amount of income spent by consumers is smaller. It can be due to a reduction in consumer confidence. The consumption function, in the above, diagram is steeper. The marginal propensity to consume in this case has increased. Individuals are spending a huge amount of their income. This can be associated with enhanced confidence and easy credit accessibility. Question two A fall in consumer confidence will result to a disappointing data on economic growth. This can be explained well by understanding aggregate expenditure and how it is related to gross domestic product (GDP). Aggregate expenditure (AE) refers to the sum of expenditures on final goods and services at a fixed price level. The expenditures include government expenditure, net export, expenditure on consumption and investment. Therefore, aggregate expenditure is simply the sum of investment, consumption, net export and government expenditure. It can be expressed mathematically as follows AE=C+I+G+(X-M) Where C is consumption I is investment G is government expenditure (X-M) is net export Among the four determinants of AE, consumption takes the largest share. Therefore, a small change in consumption can greatly affect the aggregate expenditure. Aggregate expenditure greatly determines equilibrium GDP (gross domestic product). At equilibrium GDP, aggregate expenditure should be equal to aggregate production. A change in either expenditure or production will interfere with the equilibrium position (Sexton, 2012). Therefore, aggregate expenditure model is a macroeconomic model that concentrates on the association between real gross domestic product and total spending. Macro equilibrium in an economy occurs when total expenditure equals total production, that is, Aggregate expenditure = GDP It is believed that changes in aggregate expenditure in an economy results in yearly fluctuations in GDP. Economists do always predict what will happen to the components of aggregate expenditure. If they predict that aggregate expenditure will reduce in the near future, it will be equivalent to predicting that the gross domestic product will reduce and that the economy will enter a recession. A fall in consumer confidence causes consumers to spend smaller amount of their income. This will in turn affect the total amount of consumer expenditure. A fall in consumer confidence is believed to reduce the total amount of consumer expenditure. This causes the aggregate expenditure to fall since, as mentioned earlier, the consumption takes the largest share in the aggregate expenditure model. Therefore, its reduction will cause aggregate expenditure to reduce by bigger margin. A fall in aggregate expenditure will result into GDP disequilibrium. The total amount of output produced in the economy will be greater than the total expenditure resulting into macro equilibrium in an economy. Decline in GDP is normally associated with decline in aggregate expenditure. Therefore, if consumer confidence falls, the gross domestic product will decline, thus depicting a negative growth in the economy. A fall in consumer confidence will result to a disappointing data on economic growth. Economic growth depends a lot on gross domestic product. Fluctuations in gross domestic product, brought about by a fall in consumer confidence, will greatly affect the entire economy. It is believed that fluctuations in gross domestic product will have dramatic impacts on wages, employment and profits. A decline in aggregate expenditure or gross domestic product indicates that the economy is heading to a recession (Luo, 2012). This is a disappointing data on economic growth. Question three Aggregate supply-aggregate demand model is a mere aggregation of microeconomic model. It represents the amount of output of the whole economy. Aggregate supply-aggregate demand model represents two variables, which are real domestic product (RGDP) represented in the horizontal axis and the general prices, represented on the vertical axis. The diagram below shows a simple aggregate supply-aggregate demand model In the above diagram, RDO1 is the equilibrium real gross domestic product while PL1 is the equilibrium price level. The intersection of aggregate demand and aggregate supply curves determines the inflation rate in the economy. The aggregate demand curve is downward sloping. It implies that for any amount of income, buyers will purchase more commodities at lower prices than what they could purchase at higher prices. Aggregate demand is the sum of all levels of expenditure within the national income accounts. The expenditures include consumption, government expenditures, net exports and investment. In the above diagram, the slope of aggregate supply curve is different from that of aggregate demand curve. The slope of aggregate supply curve is relatively flat for some part and nearly vertical for other part. The relatively flat region of AS curve is known as the non-inflationary region, whereas the portion that is nearly vertical is the inflationary region. Similar to microeconomic supply and demand model, there are several variables that affect the equilibrium position of aggregate demand-aggregate supply model. The slope of aggregate demand and aggregate supply curves represents the relationship between aggregate supply, aggregate demand and prices. Changes in the variables such as interest rate can make the curves to either shift to the right or to the left, thus impacting the real GDP, the general price level or inflation rate, and the employment/unemployment level. It is believed that changes in interest rate do always cause AD curves to either shift to the right or left. An increase in interest rate causes aggregate demand curve to shift to the left while a decrease in interest rate causes aggregate demand curve to shift to the right. A change in interest rate, such as interest rate cut, increases the demand for investment in the economy. This in turn causes the total demand in an economy to rise. The increase in total demand in an economy causes aggregate demand curve to shift to the right. The effect of interest rate cut is illustrated in the following aggregate demand-aggregate supply model. From the above diagram, decrease in interest rate causes the aggregate demand curve (AD) to shift to the right. The shift of aggregate demand curve from AD to AD` causes the price level and the real gross domestic product to increase. RDOFE is the full employment level of output. It is believed that unemployment normally results if the equilibrium point is below the full employment level. In this case, interest rate cut causes equilibrium point to be above the full employment level. It can therefore be concluded that interest rate cut increases the general price level and real GDP. Reduction in interest rate reduces the level of unemployment. References Hall, R. E., & Lieberman, M., 2009, Economics: Principles & Applications. Cengage Learning Luo, Y., 2012, Aggregate Expenditure and Output in the Short Run. Sexton, L., R., 2012, Exploring Macroeconomics. Cengage Learning. Tucker, B., I, 2010, Macroeconomics for Today. Cengage Learning. Read More