Macro Economics and Gross Domestic Product - Essay Example

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 economy may not function as required and may result in high levels of unemployment. Therefore, to control this the government needs to intervene. If there is high unemployment the government should opt for deficit financing to increase the spending in the economy thereby, triggering economic growth. (Bamford et al. 2003)

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 to get an equilibrium national income, a line is drawn at 45 degrees. This is because at that point the Aggregate Expenditure will be equal to the 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.

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 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 increase so does the amount of the national income (Y). The question here is how much?
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 concerning the change in the injections is known as the multiplier (k). The multiplier is equal to the change in national income Y divided by the change in injections. (Sloman, 2006)
Apart from the above explanation 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 realistic model as it has all possible sectors in an open economy: households, firms, the government, and the international trade market. As discussed earlier in the Keynesian model Aggregate Expenditure equals the total income Y. This can be represented by the following equation:
Y = C + I + G + (X – M)
Thus, this results in a new multiplier equation which is as follows:
1/ (mps + mrt + mpm)
Here mps is the marginal propensity to save while mrt is the marginal rate of taxation. Lastly, MPM is the marginal propensity to import.

http://www.stchas.edu/faculty/gbowling/macro/OpenEconomyMultiplierDerivation.html
Question 3
The relations between consumption and income can be explained and investigated using the consumption and savings functions. The consumption function tells us the amount of spending which will be spent at different levels of Y.
The consumption function is given by the equation:

C = a + bY
In the equation above C is the Consumption function. ‘a’ stands for autonomous consumption. Autonomous consumption is the amount that will necessarily be spent even if the income level is 0. Meaning this is the portion of consumption which does not vary with income. ‘b’ is the marginal propensity to consume and Y stands for the disposable income- income which is available to be spent. (Bamford et al. 2003) Therefore, the multiplication of the mpc with the Y is the induced consumption which is directly related to the levels of income in the economy. Read More