EC3102: Consider the Impact of an Increase in Thriftiness in the Keynesian Model: Macroeconomics and Public Policy Assignment,

EC3102 Macroeconomics and Public Policy Assignment

1. Consider the impact of an increase in thriftiness in the Keynesian model. Suppose the consumption function is given by C = C(bar) + c(Y – T ) where C(bar) is a parameter called autonomous consumption, 𝑐 is the marginal propensity to consume, 𝑌 is income and 𝑇 is taxes.
   (i) What happens to the equilibrium level of income when the society becomes thriftier, as represented by a decline in C(bar)?

2. (i) Consider a closed economy without government. Assume that a constant of profit (Π) is saved and that no wage (𝑊) is saved. Using the Keynesian income-expenditure accounting, derive the so-called ‘profit multiplier’ and explain the main determinant of the size of the profit multiplier.

(ii) Now introduce the government sector in the above model and let 𝐺 and 𝑇 represent government expenditure and revenues respectively. Derive the profit multiplier for this case and discuss the relationship between fiscal deficit (higher expenditure over revenues) and the level of profits in the economy.

3. 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 𝑥 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 𝐶 = 𝐶(𝑌, 𝑥); 𝐶𝑌 > 0, 𝐶𝑥 > 0, where 𝐶𝑌, 𝐶𝑥 are partial derivatives of consumption with respect to income 𝑌 and financial earnings 𝑥 respectively. Similarly, the real investment expenditure of firms is given by 𝐼 = 𝐼(𝑌, 𝑥); 𝐼𝑌 > 0, 𝐼𝑥 < 0, where 𝐼𝑌, 𝐼𝑥 are the partial derivatives of the real investment with respect to income and financial earnings. Note that 𝐼𝑥 < 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.

• Identify the “wealth effect” in this model?
• Derive the relationship between output 𝑌 and financial earnings 𝑥, and examine the analytical conditions under which the relationship is positive ( 𝑑𝑌/𝑑𝑥>0) and negative ( 𝑑𝑌/𝑑𝑥 < 0).
• Describe why the scenario where the expansion in output driven by the rise in financial earnings, i.e. when 𝑑𝑌/𝑑𝑥>0, could make the economy unstable and vulnerable to a crisis?

4. Consider the “Robinson Crusoe” economy with two markets – product market and the labour market. Assume the utility function of the consumer is given by 𝑈 = 𝑈(𝐶, 𝑅), where 𝐶 denotes consumption and 𝑅 stands for leisure, and the production technology is given by 𝑞 = 𝐹(𝐿), where 𝑞 is output and 𝐿 denotes labour input. Furthermore, assume the price of the consumer good to be equal to one, and the price of labour equal to the wage rate, 𝑤, and that the consumer and producer are price-takers. Answer the following questions:

(i) Discuss how the decentralised decision making is coordinated in this economy and derive the analytical condition that results in a Pareto-efficient exchange.

(ii) Derive the Walras Law for this economy and discuss its implications for policy.