Question

7. ECON1A

a) The money supply in Freedonia is $W billion. Nominal GDP is $X billion and real GDP is $Y billion. What are the price level and velocity in Freedonia?

b) If the price level changes, what happens to aggregate demand?

c)What is the effect of a government budget deficit on national savings?

d) In a pure free market, if people spend more of their income for consumption, what is the effect on GDP and its components?

Answer 1

(a)

(i) Price level (P) = Nominal GDP / Real GDP = $X billion / $Y billion = X / Y

(ii) As per Quantity theory, M x V (Velocity) = Nominal GDP

V = Nominal GDP / M = ($X billion / $W billion) = X / W

(b)

The Aggregate demand (AD) curve is downward sloping. If price level increases, quantity of real GDP demanded decreases, so there is an upward movement along AD curve. In price level decreases, quantity of real GDP demanded increases, so there is a downward movement along AD curve.

(c)

National savings = Private savings (Sp) + Public savings (Sg), where Sg = Tax revenue - Government spending

Budget deficit = Government spending - Tax revenue. So, a budget deficit means that Sg is negative. Sp remaining the same, a negative Sg will decrease national savings.

(d)

Higher spending on consumption will increase aggregate demand, which will increase GDP. In the next round of economic activity, higher GDP will stimulate more consumption and will increase investment demand. This in turn will increase GDP, and the process will continue.