Question

21Consumer spending and national income-how are they linked?

22What is a country’s productive capacity?

23Inflation exists when spending exceeds productive capacity-explain

24What tools does the government have to affect total spending in the economy?

Answer 1

21) Consumer spending and national income: They are very directly linked as can be seen in the national income equation:

Here, Y is the national income, C is the consumption, I is the investment, G is government expenditure and NX is net exports. The transmission process is as follows:

When consumption increases in a country, the aggregate demand for products in the country increases. When AD increases, the equilibrium price and quantity increases. To meet this increased demand, manufacturers increases the amount of goods produced leading to a rise in GDP. To increase the production, more labour is demanded leading to a rise in national income.

22) Productive capacity is the maximum possible output that a nation can produce given its capacity. For example, if a nation has a manufacturing capacity of producing $100 worth of goods per year, then this $100 is the productive capacity. It is also known as the potential output or potential gdp. However, in most cases, the actual output is less than the potential output leading to a negative output gap. Almost never a country operates on the full capacity,

23) Inflation exists when spending exceeds the productive capacity: This is true because when the spending increases, AD increases. However, since, the country cant produce more than the productive capacity, the demand exceeds the supply and according to laws of economics, price increases. If spending is continuously greater than the productive capacity then inflation will become higher and higher till demand drops.

24) The nation has two general tools to affect the total spending in the economy. These are the fiscal policy and monetary policy. The fiscal policy is in control of the government whille monetary policy is in control of the central bank. Fiscal policy is basically the government expenditure while monetary policy has to do with the interest rates. If the government wants to increase spending, government increases spending leading to higher money circulation in economy leading to higher income and higher spending. In the same case, the central bank would reduce interest rates leading to higher demand for loans and higher circulation of money in the economy leading to higher income and spending. On the other hand, if government wants to reduce spending, govt reduces spending while central bank increases inrerest rates.