ECON1040 Principles of Economics– Tutorial 7 – S1 2022
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ECON1040 Principles of Economics– Tutorial 7 – S1 2022
Tutorial 7, Week 9
1. Aggregate Demand and the Multiplier (sec. 14.2)
The multiplier mechanism is used to explain why an economic shock has a larger impact on equilibrium income than the initial impact on aggregate demand. Consider the following three shocks and describe how they might affect different components of aggregate demand:
The appearance of a new highly contagious virus for which there is no vaccine. Government directives for businesses to shutdown and individuals to self— isolate due to a pandemic.
A large decrease in the price of houses because of a global pandemic.
High government expenditures on infrastructure, reductions in taxes and increases in transfer payments.
2. The Multiplier (sec. 14.2)
Use a diagram to explain what is meant by the multiplier.
3. Finding Equilibrium Income (sec. 14.2)
Assume the economy is a simple one with no external trade and initially at least, no government expenditure (G). Suppose that the marginal propensity to consume is equal to 0.75 and autonomous consumption is equal to $600bn. If investment equals $300bn find the level of income that is consistent with equilibrium in the goods market. Assume that this level of income is consistent with full employment. Draw this in a diagram. Note thatfull employment is generally considered to require a level of unemployment of between 4 and 5 per cent.
HINT: Tofind equilibrium income you will need to solve thefollowing expressionfor Y:
AD = C + I = co + c1 Y + I = Y
Consider the impact of COVID- 19 on business confidence. Assume that businesses become substantially more pessimistic about the future state of the economy and that business decreases investment expenditures by $100bn. Find the new equilibrium level of income. What is the value of the multiplier in this case?
4. Fiscal Policy (sec. 14.5 & 14.6)
Suppose now that government has a role in the economy described in question 3. Write out a new expression for aggregate demand.
Fiscal policy is associated with governments using G to ‘smooth out’ fluctuations in aggregate demand, thereby smoothing out the business cycle and preventing unemployment rising.
Identify what is meant by fiscal policy and automatic stabilizers.
A very quick review of the news over the past year shows that governments have responded to the COVID- 19 pandemic by undertaking a number of fiscal measures. In the economy described in question 3, what fiscal measures could be put in place by governments so that income is restored to a level that is consistent with full employment?
Show this on a diagram.
5. Fiscal Policy (sec. 14.5 & 14.6)
Consider the economy described in question 3 in which there has been a negative economic shock associated with the appearance of the COVID- 19 pandemic. How do automatic stabilizers assist with smoothing out the business cycle?
6. The Multiplier and the Ineffectiveness of Fiscal Policy (sec. 14.5, 14.6 & 14. 7)
The model of the economy considered in questions 3, 4 and 5 suggest that government actions (such as increases in the value of G, government expenditures) or reductions in taxes will increase aggregate demand and equilibrium income. Why might this not be the case?
Key Terms
Note that at the end of each tutorial I will identify some additional key terms or concepts that you should be familiar with. These will not be discussed in class but are examinable:
• Aggregate demand
• Autonomous consumption
• Marginal propensity to consume
• Multiplier
• Household target wealth
• Fiscal policy
2022-05-28