Investment Multiplier, Aggregate Demand, Monetary and Fiscal Policies - Assignment Example

Question 1 Investment multiplier looks at establishing the required relationship given propensity to consume and the impact it will have on aggregate employment and income along with the rate of investment. This multiplier helps to find out the manner in which an increase in investment will result in an increment in income which will be K times the increment in investment. This thereby helps to understand the manner in which increment of investment results in increase in income. This is calculated as K=∆Y/∆I, where Y is income, I is investment, ∆ is change (increment or decrement) and K is the multiplier. Investment multiplier has its importance for the economy as it helps to determine the manner in which change in propensity to consume has an impact on the level of investment. This helps to understand the change that an additional increment in investment results from a change in income. This thereby helps the economy to decide the amount of goods and services that needs to be produced. This helps to analyze the cumulative effect that change in investment has on income thereby helping the economy to decide the increment in investment that has to be made. For example suppose the propensity to consume is 0.5 and investment is increased by 100 then it will lead towards an increase in investment of 200 (100 / 0.5). The investment multiplier is determined K=∆Y/∆I, where Y is income, I is investment, ∆ is change (increment or decrement) and K is the multiplier. It looks towards analyzing the manner in which changes in income leads towards changes in investment as the multiplier effects results in a higher changes as compared to the increment in income. Question 2 a. Y = C + I + G + NX where C = 1,000 + 0.65Y I = 1,500 G =1,500 NX = -500 So Real GDP (Y) = 1000 + 0.65Y + 1500 + 1500 + (-500) 0.35Y = 3500 Y = 3500 / 0.35 Y = 10,000 b. Now Marginal Propensity changes from 0.65 to 0.75 then Y equals to Y = C + I + G + NX where C = 1,000 + 0.75Y I = 1,500 G =1,500 NX = -500 So Real GDP (Y) = 1000 + 0.75Y + 1500 + 1500 + (-500) 0.25Y = 3500 Y = 3500 / 0.25 Y = 14,000 A change in marginal propensity to consume to 0.75 from 0.65 results in a change in real GDP (Y) by 14000 – 10000 = 4000. Question 3 Aggregate demand is the total value of goods and services which is demanded by the economy at a certain price level whereas aggregate supply is the total value of goods which the supplier are willing to supply in the economy at a given price. Thus aggregate demand and aggregate supply are different curves which represents the demand and supply of goods and services in the economy and helps to find out the level at which equilibrium will be determined in the economy. a. Increase in Price Level Increase in the price level will result in the aggregate demand curve to move downwards as certain section of the society would refrain from purchasing some products at the higher price which would thereby make the demand curve move downwards and is as b. Increase in government purchase Increase in government purchase will result in the aggregate demand curve to move upwards as overall demand for the products would increase which would thereby make the suppliers supply more at the given price which would thereby make the demand curve move upwards and is as c. Increase in Income Tax Increase in income tax will result in the aggregate demand curve to move downwards as the spending power of individuals will decrease due to decrease in disposable income which can be spent on expenditure which would thereby make the demand curve move downwards and is as d. Higher Interest Rates Higher interest rate will result in the aggregate demand curve to move downwards as certain section of the society would refrain from purchasing some products at the higher price due to high interest rate which would thereby make the demand curve move downwards and is as Question 4 Monetary and fiscal policies are tools which are used to influence the different activities which take place within the economy. Monetary policy looks towards managing the interest rates and the total amount of money which will be in circulation within the economy and is carried out by central bank of the economy. Fiscal policies on the other hand looks at making changes in the tax rates and government spending so that money within the economy can be controlled and is carried out by the government. The monetary policy is used by the central bank to stimulate the economy so that steps can be taken to accelerate the economy growth rate or decrease the growth rate based on the inflation rate which is prevalent within the economy. The central bank uses different tools like open market operations, changing the reserve requirements and setting the discount rate. In a similar manner fiscal policy is used by the government to stimulate the economy so that steps can be taken to accelerate the economy growth rate or decrease the growth rate based on the inflation rate which is prevalent within the economy. The government uses different tools like change in government spending and change in tax. During inflation government looks to control inflation by making changes in the fiscal and monetary policies. The government to control inflation can look to control aggregate demand by reducing the government spending so that money within the economy can be controlled. In addition to it the government can look at increasing the tax rate so that disposable income reduces and the government can control inflation. In a similar manner monetary policies can also be used by the central bank to control inflation. The central bank can look at tightening the monetary policy by increasing the interest rate so that consumer spending and investment spending can be reduced. In addition to it selling securities in the open market will help to reduce the amount of money in the economy and will thereby help to control inflation. Further, increasing the reserve requirements will help to ensure that banks keep more funds which would thereby reduce the amount of money they can lend for investment purpose thereby helping to control inflation. Thus a mix of monetary and fiscal policies will help to reduce inflation. Read More