KENYA METHODIST UNIVERSITY

NAKURU CAMPUS

SCHOOL OF BUSINESS AND ECONOMIC

DEPARTMENT OF ECONOMIC AND STATISTIC

NAME : ZACHARIAH DAU ATEM

REG NO : BUS-1-5691-3/2016

COURSE TITLE : INTERMEDIATE MACRO-ECONOMIC ANALYSIS

COURSE CODE : ECON 302

LECTURER : MR. MICHAEL KIAMA

DATE OF SUBMISSION : JULY 21ST, 2018

TASKS : ASSIGNMENT
Answer all questions.
Question One
a). Describe the circular flow of income in four sector economy.

Circular flow of income in a four-sector economy consists of households, firms, government and
foreign sector.

Household Sector

Households provide factor services to firms, government and foreign sector. In return, it receives
factor payments. Households also receive transfer payments from the government and the foreign
sector. Households spend their income on:

(i) Payment for goods and services purchased from firms;

(ii) Tax payments to government;
(iii) Payments for imports.

Firms

Firms receive revenue from households, government and the foreign sector for sale of their goods
and services. Firms also receive subsidies from the government. Firm makes payments for: (i)
Factor services to household

(ii) Taxes to the government;

(iii) Imports to the foreign sector.

Government

Government receives revenue from firms, households and the foreign sector for sale of goods and
services, taxes, fees, etc. Government makes factor payments to households and also spends money
on transfer payments and subsidies.

Foreign Sector

Foreign sector receives revenue from firms, households and government for export of goods and
services. It makes payments for import of goods and services from firms and the government. It
also makes payment for the factor services to the households.
b). Suppose the level of autonomous investment in an economy is 200 and the consumption
function is C=80 +0.75Y. Find the equilibrium level of income

Solution:

Y= C+I AS=AD, I = 200, C = 80 + 0.75Y

Y = 80 + 0.75Y + 200 =
Y- 0.75Y = 80 + 200 =
(1 – 0.75) Y = 280
(0.25) Y = 280
0.25 Y = 280
0.25 0.25
Y= 1,120

Equilibrium level of income is therefore equal to 1,120

c). what will be the increase in national income if investment increases by 25

I = 200+25 = 225
Y=80+0.75Y+225
Y-0.75Y = 225+80
0.25Y/0.25 = 305/0.25
Y= 1220
National income = 1220 - 1120= 100
Hence increase in national Income is Sh.100

Question two
a). Suppose the level of planned investment in an economy is 200 and the savings function is
given by S=-80+0.25Y, Find equilibrium level of income

Solution
Equilibrium is achieved when two assumptions are in equal:
 Aggregate expenditure or demand = Aggregate supply or output
  Intended investment = Intended savings

Equilibrium level of income = saving = Investment

Y = -80 + 0.25Y = 200

Y-0.25Y = 200 +80

0.75Y = 280
Y = 280/0.75
Y = 373.33
b). Suppose the consumption function is given by C=20+0.6Y and the following
investment function is given I=10+0.2Y find the equilibrium level of income.

Solution:
Y=C+I
Y = 20 + 0.6Y +10 +0.2Y =
Y = 0.6Y+0.2Y = 20+10
Y-0.8Y = 30
Y (1 – 0.8) = 30
0.2Y = 30
0.2 0.2
Hence Y = 150

c). given the three equations for the determination of equilibrium level of national
income, Y=C+I, C=a +b Y and I=Io .Suppose an economy has autonomous
investment of 600 and the consumption function is given by C=200+0.8Y. Find
equilibrium level of income.

Solution:
Y= C + I , C = a + b Y and I = Io.

Y = 200 +0.8 Y + 600

Y = 0.8 Y + 800
Y- 0.8Y = 800
 Y ( 1- 0.8) = 800/0.2
Y = 4000

d). A hypothetical closed economy has a national income model of the form Y=C+I+G
where C =30+0.8Yand I and G and private investment and government expenditure are
exogenously determined at 50 and 80 units respectively. Compute the national equilibrium
level of income for this economy using aggregate income equals aggregate expenditure.

Solutions:

Y= C+I+G Where C = 30 + 0.8Y, I = 50, G = 80

AI = AE
Y = 30 + 0.8Y + 50 + 80 =
Y = 0.8Y + 160 =
Y- 0.8Y = 160
Y (1-0.8) = 160
Y = 160/0.2
Y = 800
Equilibrium level income = 800

e). Briefly explain the Keynesian Theory of Consumption

It states that the aggregate real consumption expenditure of an economy is a function of real
national income. The Keynesian theory of consumption tells that consumption rises with income.
This relationship between consumption and income is central to Keynes‘s model of the economy.
While Keynes recognize many factors include wealth and interest rate plays a greater role in
determining consumption level in the economy.

Keynes stated that the rate of interest may have some influence on consumption but the real income
was the important determinant of consumption.
The classical economists used to argue that consumption was a function of the rate f interest such
that as the rate of interest increased, the consumption expenditure decreased and vice versa.
Question Three
a). Given a hypothetical four-sector economy model such that
Y = C + I + G + (X - M) and that C = α + βYd and M = M0 + K(Y)
Y = output level
T = Lump sum tax
I = Investment
G = Government spending
(i). Describe the meaning of α, Yd and β terms as used above

α, is autonomous consumption expenditures which do not depend on the level of national income
(independent).
Yͩ is disposable income which remains after taxations. Income that remains after consumers have
received transfer from the government and paid taxes. It can use for consumption or to save.
β, is marginal propensity to consume which refers to the change in the consumption that arises
from additional unit of income.

(ii). Derive Government expenditure multiplier with tax

Government expenditures multiplier with tax = Y = C[Y-T]+1[Y,i]+G or G + T = 1/1-b + -b/1-b

a). Given that

I = 300; G = 400; T = 200; X = 100, α = 500; β = 0.60; M0 = 50 and K = 0.40

Calculate
(i). National income at equilibrium (Y)
Y = C+I+G+[x-m]
Y = 500+0.6[Y-200]+300+400+[100-50+0.4]
Y = 1200+0.6Y-120+50-0.4Y
Y = 1130+0.6Y-0.8Y
Y = 5650
(ii). Consumption (C)
C = a+bY ͩ
C = 500+0.6[5650-200]
C = 3770

(iii). Imports (M)

M = Imports
M = Mo+K[Y]
M = 50+0.4[5650]
Therefore, Imports = 2310

a). Discuss the quantity interpretation of LM-curve

LM curve is a curve that joins various combination of income and interest rate at which monetary
sector that is money market is in equilibrium. It is possible to derive the LM curve by adopting the
quantity theory approach. The quantity of exchange MV = PY gives us the equilibrium condition of
the money market. If V is assumed to remain constant, the equation is converted into the quantity
theory of money.
The assumption implies that for any given price level, P this supply of money, M is determined by
the level of income Y.
dM dV dP dY
+ = +
M V P Y
Therefore the slope of the LM curve is positive. At all the point s along the curve, the
demand for the money is equal to the supply of money. For instance rising in the
interest rate must be accompanied by a rise in national income.

Question four 1 1
Money demand and money supply is given by (M/P) d = 1000r and (M/P)S=1000 and the price
level is 2
a). Graph the supply and demand for real money balances

r
(M/P)s
1

0.5

(M/P)d

500
M/P

The downward sloping line represents the money demand function, which is 1000 r.
With M = 1000 and P = 2, the real money supply is 500. The real money supply is
independent of the interest rate and is, therefore, represented by the vertical line.
b). what is equilibrium interest rate?

Equilibrium interest rate is the rate at which the supply for money meets its demand. It is
used by the central bank. It tied the demand and the supply of money. It occurs at the
point where the demand for a particular amount of money equal to the supply of Money.
Set the supply and demand for real balances equal to each other:

500 = 1000r
r = 0.5, so the real interest rate is 0. 5%

c). Assume the price level is fixed. What happens to equilibrium interest rate if the supply
of money is raised from 100 to 1200

With an increase in money supply from 100 to 12000, the new supply of real balances
is 14000. We can solve for the new equilibrium by once again setting demand equal
to supply:

14000 = 1000 r
r = 14.

d). If the central bank was to raise the interest rate to 7% what money supply should it
set?

In equilibrium, M/P = 1000 r. Setting the price level at 2 and substituting r = 7, we

find:

M/2 = 1000 *7
M = 14000.
 Thus the bank must increase the nominal money supply from 100 to 14000.

Question five
a). What is the difference between depreciation and devaluation?
Depreciation is the change in the value of money that has its value determined by the market
forces and buys and sell rate, generated in the open money market.
Depreciation happens in a country with floating exchange rate. Floating exchange rate mean the
investment market is determined by the value of country currency.
Devaluation refers to change in the value of a money that has its value set by the country
government and the value does not t float in the open monetary market.
Devaluation happens in a country with a fixed exchange rate. The Government decide what its
currency should be worth compared with that of other countries.

b). According to Mundell Fleming model, when the exchange rates are fixed and capital is
perfectly mobile will fiscal and monetary policy be more successful? Explain.
According to Mundell Fleming model, when the exchange rates are fixed and capital is
perfectly mobile will fiscal and monetary policy be more successful ?Explain
When exchange rated are fixed and capital mobile, then fiscal policy is more effective because it
has a larger impact on the domestic economy leading to full employment. It follows that when
capital mobility is perfect, interest rates in the home country cannot deviate from those
prevailing abroad. It is quite evident from above that with perfect mobility of capital under fixed
exchange rate regime; monetary policy in a small open economy is quite ineffective to influence
the levels of national income and employment.

c). what are the advantages of floating exchange rates and fixed exchange rates?

Advantages of floating exchange rates:

  Protection from external shocks - if the exchange rate is free to float, then it can change
in response to external shocks like oil price rises. This should reduce the negative impact
of any external shocks.
 Lack of policy constraints - the government are free with a floating exchange rate system
to pursue the policies they feel are appropriate for the domestic economy without
worrying about them conflicting with their external policy.
 Correction of balance of payments deficits - a floating exchange rate can depreciate to
compensate for a balance of payments deficit. This will help restore the competitiveness
of exports. There is a link to Figure 1 below which illustrates the operation of the
automatic adjustment mechanism under a floating exchange rate system.
 It provides an indication of relative scarcity of currency which leads to better allocation
and eliminates the possibility of overvaluation of currencies.
 Floating exchange rate lead to automatic stabilization since any balance of payment
disequilibrium can be rectified by changing the fixed rate.

Advantages of fixed exchange rates:

 Absence of speculation - with a fixed exchange rate, there will be no speculation if

people believe that the rate will stay fixed with no revaluation or devaluation.
 Constraint on government policy - if the exchange rate is fixed, then the government may
be unable to pursue extreme or irresponsible macro-economic policies as these would
cause a run on the foreign exchange reserves and this would be unsustainable in the
medium-term.
 Fixed exchange Rate make international trade more stable since they reduce uncertainty
about the value of the exchange rate and it is therefore to make a plan about trade and
investment.
 It forces a country to take corrective action and measures to remedy a balance of payment
deflect rather than simply relying on a change in the exchange rate

d). Define the aggregate supply curve

It refers to the relationship between price level and the quantity of output that firms are willing to
provide. Normally it shows positive relationship between aggregate supply and price level. It
depicts the quantity of real GDP that is supplied by the economy at difference price level.

e). What is the difference between the classical and Keynesian supply curve

In Classical , Aggregate supply Curve is vertical i.e. the prices level are on y axis, meaning
that output is fixed and prices are flexible so that if demand curved change then the effect will
be entirely on price level and not on output . In the classical model, aggregate supply curve is
vertical, meaning that output is fixed and constrained by. Therefore the Government doesn’t
intervene only the economy will correct itself

In Keynesian supply curve: The aggregate supply curve is horizontal and flat in recession at
same price level, if the demand changes, the effect will be entirely on output. The Government
will move the aggregate demand curve by spending more money, increasing GDP without
increasing prices.

f). Discuss the effect of an expansionary monetary policy on the economy

 Expansionary Monetary policy spurs economic growth during recession, adding money
to the economic system, lowering interest rate and ease the credit restrict that bank
apply to loan application. This mean the consumers and businesses can borrow money
easily and spending more.
 Spending more money by consumers, businesses enjoy revenues and profit, this allow
companies to have more update plants and equipment assets which create more
employment as company borrow easily for it operations.
 Price stability: inflation results from having too much money cashing available goods and
services and this lead to the money losing it values in relations to the purchasing power.
On the other hand, expansionary monetary policy restricts deflation which occurs in the
recession time. Where there is a shortage of money in circulation and companies
lowering their prices in order to attract businesses. These results in higher unemployment
and reduce wages.
References:

1. Robert Mududa, second edition 2013 , Modern economics

2. Mastering your economic fifth edition by Jack Harvey
3. Essentials of Economic fifth edition 2011 by John Sloman & Dean Garratt
4. Principle of ecomic tenth edition by Karl. E. Case and Ray. C. Fair & Sharon M.
5. Fred learn Modern Economic.