Question

Assume there is no international trade (X = IM = 0) but there are private investments, government expenditure and taxation.

(a) Use the goods market equilibrium condition to demonstrate that in equilibrium “saving equals investment”. Clearly explain what is “saving” and its components.

(b) The behavioural functions of this economy are given below Consumption: C = 10+0.6(Y-T) Investment: I = 2+0.2Y Government: expenditure: G = 2 Taxation: T = 4 Solve the total saving function. Put total saving ST on the left and anything else on the right side. The function should show how income affects total saving.

(c) Draw the ST=I diagram to show the equilibrium. Clearly indicate the numerical values for all the intercepts and the equilibrium output in the diagram.

(d) Based on the model above, which items will affect autonomous saving? If autonomous saving increases, will saving in equilibrium be higher or lower? Illustrate this situation in the ST=I diagram.

Answer 1

(a) In equilibrium we know AD=AS, therefore

Y=C^d+I^d+G₀

• C^d = demand for consumption goods
• I^d = demand for investment goods
• G₀=exogenous spending for goods and services

Y-C^d-G₀=I^d

In equilibrium, desired national saving is defined as

S^d=Y-C^d-G₀

therefore, S^d=I^d

hence, in our economy without a foreign sector we have equilibrium in the market for goods and services if desired national savings is equal to desired investment expenditure.

Saving is defined as the excess of income over consumption expenditure. The concept of saving is closely related to the concept of consumption. Saving is the part of income that is not consumed. Generally, as the level of income increase, saving also increases and vice versa.

components of saving are

1. Income (Y)
2. consumption (C)
3. government expenditure

(b) C=10+0.6(Y-T)

I=2+0.2Y

G=2, T=4

since, Y=C+I+G

so, Y= 10+0.6(Y-4)+2+0.2Y+2

Y=10+0.6Y-2.4+2+0.2Y+2

Y=11.6+0.8Y

0.2Y=11.6 => Y= 58

C = 10 + 0.6(58-4)

C= 10 + 0.6(54) = 10 + 32.4

C=42.4

As we know, S = Y - C - G

S = Y - [C+b(Y-T)] - G = Y - C - b(Y- T) - G _____(1)

=Y(1-b)-C+bT - G= 58(0.4) - 10 + (4)0.6 - 2

=23.2-10+2.4 - 2

S=13.6

equation (1) shows total saving function will be affected by any change in the right side of equation.

I= 2+0.2(58) = 13.6

(c)