In: Economics
Question 2
question 2.1
Give an example of a situation when an economy is in recession
according to both definitions of recession and give another example
of a situation when an economy may be in recession according to one
of the definitions but not the other.
You answer.
question 2.2
Consider two identical countries. The only difference between them
is that in country A the marginal propensity to consume (out of
disposable income) MPC=0.4 and in country B MPC=0.7. The marginal
tax rate t=0.2. I=20,000, G=10,000, NX=25,000-0.2Y (where Y is
total income), c0=15,000.
a) Calculate the multiplier in both countries (round up to two decimal places)
You answer.
b) (i) What would be the equilibrium levels of output
in country A and country B?
You answer.
(ii) Show the equilibrium levels of output in country A and country
B on a well labelled graph with aggregate demand on the vertical
axis and output (income) on the horizontal axis.
You answer.
c) Now assume that consumers lose their confidence and
decrease autonomous consumption c0 from 15,000 to 10,000. What will
happen to output in both countries? Which country will have a
larger effect on its GDP? Illustrate using the graph from part b).
You answer.
question 2.3
Usually investment depends on the interest rate. Briefly explain
how an increase in the interest rate r would affect aggregate
investment. Use a reference to the expected rate of profit in your
explanation. (Word limit: max 100 words)
You answer.
2.1 The two definitions of recession includes fall in output for two consecutive quarters and the declining inflation. During recession, output tends to fall due to various reasons like higher oil prices, investment market crash, etc., A recession is identified by a decline in total output, rise in unemployment and decline in inflation. As the demand for commodities falls during recession, firm's actual inventory of goods is higher than the planned inventory and therefore, prices of the commodities fall. Lower demand and lower economic activity leads to a fall in inflation.
Example of a recession where both output and inflation declined is the 1991 recession where the economic activity declined due to tightened monetary policy and Tax reform Act of 1986 which led to resulting in sinking property values, lowered investment incentives, and job loss. The recession led to lowered inflation rate and slower economic activity.
However, declining inflation rate is not guaranteed in recession. The period of recession where there is lower economic activity but the inflation rate is also increasing is known as Stagflation. Stagflation was observed after the oil price shock of 1974 and 2008.
2.2.
Y = C0 + MPC (Y-tY) + I + G + NX
Y = (C0 + I + G +25000) + {MPC(1-t) -0.2}Y
Y - {MPC(1-t) -0.2}Y = (C0 + I + G +25000)
Y [1- {MPC(1-t) + 0.2}] = (C0 + I + G +25000) => Y = (C0 + I + G +25000) / [1- {MPC(1-t) + 0.2}]
Multiplier = 1/ [1-{MPC(1-t)} + 0.2]
Country A = 1/[1-{0.4(1-0.2)} + 0.2] = 1/[1-{0.4 *0.8} + 0.2] = 1/(1-0.32+ 0.2) = 1/0.88 = 1.14
Country B = 1/[1-{0.7(1-0.2)} + 0.2] = 1/[1-{0.7 *0.8} + 0.2] = 1/(1-0.56+ 0.2) = 1/0.64 = 1.56
b) (i) What would be the equilibrium levels of output
in country A and country B? (2 marks)
Country A, Y* = Y = (C0 + I + G +25000) / [1- {MPC(1-t) + 0.2}] = (15000+ 20000+10000+25000) *Multiplier
Y* = 70000*1.14 = 79,800
Country B, Y** = 70000 *1.56 = 109,200