Question

1. In a closed economy with no government, the equilibrium level of income is £22 billion, the full employment level of income is £25 billion. To reach full employment would require an injection of £1 billion. Explain how could the economy reach full employment equilibrium level of income £25 billion?

Answer 1

The current level of income is $22 billion, but after injection of $1 billion into the economy, the income reaches its full employment level at $25 billion. This happens by the multiplier effect which means that the income increases by a multiple of the government expenditure. This happens because consumers consume a fraction of their additional income depending 9n their marginal propensity to consume. Suppose consumers consume 90% of their income, then the marginal propensity to consume is 0.9. In this case, the consumption multiplier is given by 1/(1-0.9) = 10 which means that the additional government expenditure leads to 10 times the increase in consumption and thereby the income. In the present case, the multiplier is 3 since an increase in expenditure by 1 causes income to increase by (25-22) = 3. In this way the income is brought to full employment level through the multiplier effect.