Question

Be sure you ANSWER ALL PARTS OF EACH QUESTION.

INSERT YOUR ANSWERS UNDER EACH QUESTION – FIVE LINES MAXIMUM

1. A hypothetical economy is simultaneously experiencing an average propensity to consume of .90 and a marginal propensity to consume of .80. Explain in detail what this means. Be specific.

2. Who or what is the active participant in the fiscal policy model discussed in the text. Be sure to explain the appropriate response to a recessionary downturn and an inflation. Be specific.

Answer 1

1.

• Average propensity to consume(APC) refers to the ratio of consumption expenditure to the corresponding level of income.

APC = Consumption (C) / Income (Y)

and APC is given 0.90 which means that 90% of income is spent on consumption or we can say if national income is 100 crores then consumption expenditure is Rs 90 crores.

• Marginal propensity to consume refers to the ratio of change in consumption expenditure to change in total income. MPC explains what proportion of change in income is spent on consumption.

MPC = Change in Consumption (∆C) / Change in Income (∆Y)

and Mpc is given 0.80 that means 80% of the incremental income is spent on consumption or we can say that consumption expenditure increases from Rs 70 crores to Rs 150 crores with an increase in income from Rs 100 crores to Rs 200 crores then MPC will be 0.80

2.fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy.so government is the active participant in the fiscal policy.

There are two types of fiscal policy: Expansionary and Contractionary.

• When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.
• Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.