Question

Assume a closed economy without Government. However, there exists a financial sector that creates an array of financial assets on which both households and firms invest. Let ? denote the average earnings from these financial assets. The consumption expenditure of the households is influenced by their wage income and the financial income and is given by ? = ?(?, ?); ?? > 0, ?? > 0, where ??, ?? are partial derivatives of consumption with respect to income ? and financial earnings ? respectively. Similarly, the real investment expenditure of firms is given by ? = ?(?, ?); ?? > 0, ?? < 0, where ??, ?? are the partial derivatives of the real investment with respect to income and financial earnings. Note that ?? < 0 implies that the real investment falls as financial earnings for the firm rises. Either using the Keynesian cross model or the Multiplier analysis, answer the following questions. (i) Identify the “wealth effect” in this model? [2] (ii) Derive the relationship between output ? and financial earnings ?, and examine the analytical conditions under which the relationship is positive ( ?? ??>0) and negative ( ?? ?? < 0). [15] (iii) Describe why the scenario where the expansion in output driven by rise in financial earnings, i.e. when ?? ??>0, could make the economy unstable and vulnerable to crisis? [8]

Answer 1

I. There are basically two model, a. Consumption Expenditure Model and b. Investment Expenditure Model. The effect is present in Investment Expenditure Model as wealth comes after investment only.

ii. There is a questionable relation between x and y. As a result, use increases as a result of x build up leading to expansion in y. When x increases, investment decreases. Output equates with the sum of consumption and investments and the final effect on output of x would be dictated with the force of use or interest in the output.

iii. With increasing capital gains, people's wages will increase their use and then their overall return. With the increase in production, people will invest more income on equity and thus again lead to higher output due to the capital gain. This would self-perpetuate and cause both production and capital gain to increase continuously. This dynamic subject to the economic capability could be limited.