UNIVERSITY OF GUYANA

FACLTY OF SOCIAL SCIENCES

ACADEMIC YEAR 2019/2020 (Semester II)
DEPARTMENT OF ECONOMICS
ECN 1200- INTRODUCTION TO MICROECONOMICS
Week Six Exercise

Question 1

Marginal Propensity to Consume(MPC) = change in consumption ÷ Change in income

However, when the consumption function is given the MPC = b (slope of the consumption function)

C = a + bYD

Marginal Propensity to Save (MPS) = change in savings ÷ change in income

However, when the savings function is given the MPS = b (slope of the savings function)

S = -a + bYD or it can be written as S = -a + (1-mpc)YD

MPS = 1- mpc

MPC = 1- mps

(a) Explain why the sum of the MPC and MPS is equal to 1.

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 (b) Distinguish between autonomous consumption and induced consumption.
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(c) Give a brief account of the following

(i) Determinants of consumption

(ii) Demand for investment
(iii) Government purchases function
(iv) Net export function
(v) Non income determinants of net exports

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(d) Give a brief account of the Keynesian cross model with a clear description of the Keynesian 45
degree line.

The graph above shows the Keynesian cross model. The 45 degree line shows the points where

Aggregate expenditure is equal to income. (Y=E)

The second line is the aggregate expenditure line which shows the sum of the expenditures in the
economy: Consumption, investment, government and net exports.

The point where the two lines meet is considered the macroeconomic equilibrium.

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Question 2

(a) Define the Multiplier

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 The Multiplier(K) :

C=a+bYd, Yd= Y-T

Multiplier = ΔY/ΔAE or 1/ (1 – MPC) or 1/ MPS MPS+MPC=1

Government spending multiplier: K = 1/ (1-mpc)

Tax payer multiplier: –b/ (1 – b)= -MPC/MPS

Example:

Example – Tax Multiplier

Suppose the MPC is 0.6 and the tax cut is $100 million, then the increase in real GDP (aggregate income)
will be

ΔY = -b/ (1-b) x T MPC=0.6, MPC+MPS=1, 1-0.6= 0.4

ΔY = (-0.6/0.4) * -100

ΔY = $150 million

(b) Suppose that government wants to fund a project, which costs $10 million dollars and decides
to raise funds for the project by increasing its tax revenues by $10 million. What is the final
impact on aggregate income? Assume MPC is 0.8 MPS= 1-MPC= 1-0.8 = 0.2

ΔY = -b/ (1-b) x T ΔY = 1/(1-mpc) x G FI= 50 -40 = 10

= 1/(1-0.8) x 10

ΔY = (-0.8/0.2) * 10 = (1/0.2) x 10

ΔY = -4 x 10 = 5 x 10

= -40 = 50
 (c) Solve for equilibrium income (Y = C + I + G)
when C = 85 + 0.5YD (YD = Y – T)
T = -40 + 0.25Y
I = 85
G = 60

Y=AE=GDP= C+I+G+(X-M)

Answer:

Y=C+I+G

Y = 85 + 0.5YD + 85 + 60

Y = 85 + 0.5( Y – T) + 85 + 60

Y = 85 + 0.5[ (Y – (-40 + 0.25Y)] + 85 + 60 1Y – 0.25Y = 0.75Y

Y = 85 + 0.5 ( Y + 40 – 0.25Y) + 85 + 60

Y=85+0.5 (Y-0.25Y+40) +85 +60

Y = 85 + 0.5( 0.75Y + 40) + 85 + 60

Y = 85 + 0.375Y + 20 + 85 + 60

Y = 85 + 20 + 85 + 60 + 0.375Y

Y = 250 + 0.375Y

1Y – 0.375Y = 250

0.625Y = 250

Y = 250 ÷ 0.625

Y = 400

Question 3

(a) Complete the following table change in income = 100

Change in consumption = 75

Y (income) (C)Consumption Savings(S) APC MPC APS MPS

0 50 -50 - - - -
100 125 -25 1.25 0.75 -0.25 0.25
200 200 0 1 0.75 0 0.25
300 275 25 0.92 0.75 0.083 0.25
400 350 50 0.875 0.75 0.125 0.25
 (b) Calculate the multiplier from the table above
K = 1/mps = 1/0.25 = 4

K= 1/(1-mpc) = 1/(1-0.75) = 1/0.25 = 4

(c) Given the consumption function calculate the Multiplier

C = a + bYD mpc is the letter b in the consumption function

C = 85 + 0.7 YD

K = 1/(1-mpc) = 1/(1-0.7) = 1/0.3 = 3.3

(d) C= 100 + 0.6Y

I = 500
G= 200

(I) Calculate the level of income in the economy.

Y=C+I+G
Y = 100 +0.6Y + 500 + 200
Y = 100 + 500 + 200 + 0.6Y
Y = 800 + 0.6Y
Y – 0.6Y = 800
0.4Y = 800
Y = 800 / 0.4
Y = 2000
 (II) If the government raises nominal expenditure to 400, then what is the increase in real
income in the economy?

Y=C+I+G

Y = 100 + 0.6Y + 500 + 400

Y = 100 + 500 + 400 + 0.6Y

Y = 1000 + 0.6Y

Y – 0.6Y = 1000

0.4Y = 1000

Y = 1000/ 0.4

Y = 2500

Change RGDP = 2500 – 2000 = 500

 Question 10: Which is not an exchange rate regime adopted by Nations?

Ans: There are only three exchange rate regimes- Fixed (pegged) exchange rate, freely
floating and Managed Float(dirty float)

 Question 7: To prevent the external value of its currency rising the government could:
Ans: If there are steady increases in the value of a nation’s currency (an appreciation)
maybe because demand for that currency is rising(upward shift) , then to avoid such
increase in the value of the dollar the government can increase the supply of the dollar
(downward shift of the supply curve) and this will gives a lower equilibrium exchange
rate……..thus preventing it from rising further.

 Question 1:
 The US dollar has appreciated (it got more expensive) against the euro. This can be seen
on the graph where previously the price of US$1 was e1 and as the demand for the US
dollar increase equilibrium exchange rate increased to e2 which is the new and higher
price for US$1.

 Question 5: If the exchange rate is above the equilibrium level of exchange rate then in a
floating exchange rate system..
Answer: The quantity of the dollar supplied exceeds the quantity demanded. There is
excess supply and the exchange rate should fall to restore equilibrium.

 Question 6: If the exchange rate is below the equilibrium exchange rate level then in a
floating exchange rate system
Ans: To answer this question it is best to draw an equilibrium situation and then indicate
the new exchange rate is below the equilibrium (opposite to the graph above). You will
 see that at the new exchange rate quantity of the dollar demanded will exceed quantity
supplied

INTERNATIONAL TRADE

 Question 1: International trade only involves the exchange of goods and services:
Ans: False- When countries open up to trade, they exchange goods, services and capital
(fixed)

 Question 8: Tariffs and quotas have the same welfare effects.

Ans: Tariff is a tax on the value of imports of a commodity whereas quotas are
restrictions on the quantity of imports of a commodity.
When the government impose a tariff on imports it will restrict the importation of a
commodity since that commodity is now expensive and so too does the quota, it reduces
imports and domestic and more specifically infant industries will manage to grow.

 Question 5: A country cannot have absolute advantage in both commodities

Ans: False, given the same amount of resources a country can produce more of both
traded commodities than its trading partner and in that way it has the absolute
advantage.

 Question 6: A country cannot have comparative advantage in both commodities even if

they have the resources in abundance
Ans: True, Since comparative advantage looks at the opportunity cost of production,
logically if one country can give up less to produce one traded commodity as compared
to its trading partner, then it is quite impossible for that same country to give up less of
the other traded commodity to produce the other commodity.

 Question 4: England has the comparative advantage in the production of wine whereas
Portugal has the comparative advantage in Cloth (calculate opportunity cost)

Ans:

Formula for opportunity cost : giving up ÷ want to produce

If England wants to produce cloth it has to give up wine production:

110÷60 = 1.83 barrels of wine has to be given up to produce 1 bolt of cloth

If England wants to produce wine it has to give up cloth

60÷110 = 0.54 bolt of cloth has to be given up to produce 1 barrel of wine

If Portugal wants to produce cloth it has to give up wine production

70÷120 = 0.58 bottle of wine has to be given up to produce 1 bolt of cloth

If Portugal wants to produce wine it has to give production of cloth

120÷70 = 1.71 bolt of cloth has to be given up to produce 1 barrel of wine

England has the comparative advantage in the production of wine since it has to give up less
cloth than Portugal to produce 1 barrel of wine.

Portugal has the comparative advantage in the production of cloth since it has to give up less
wine than England to produce 1 bolt of cloth.

The END