Intermediate Macroeconomics Assignment 1

1. The goals of macroeconomic policy are:

a) Full employment –this means achieving the highest level of employment in an
economy. It occurs when the number of people unemployed are equal to the number
of job vacancies.
b) Low and stable inflation –this is an inevitable rate of inflation that is less variable and
promotes economic growth e.g. ranges from 2 to 5%
c) Economic growth –means an increase in real GDP over time.
d) More equitable distribution of income –this means reducing the gap between the rich
and the poor.
e) Balance of payments equilibrium –this means ensuring that the money entering the
country is equal to the money leaving the country.
f) Reduction in poverty –this means reducing the number of poor people in a country.
g) Economic development –Implies achieving sustainable economic growth that is
associated with falling inequality and reduction in poverty hence improvement in the
quality of life.
h) Stable Exchange rate –this means avoiding wild fluctuations in the external value of a
currency.

2. Short comings of GDP in computing National statistics

a) It does not capture output produced for own consumption -e.g. back yard gardening is
part of economic activity but is not included in official statistics of national income
accounting but they contribute to economic welfare.
b) It does not include informal activities –informal activities like unregistered carpenters
contribute to a nation’s output and welfare but may not be included in the official
transactions.
c) Does not take into account the improvement in quality of goods produced –
improvement in quality of output increases welfare yet GDP does not indicate such an
element but rather focuses on quantity.
 d) Does not reflect the quality of environment from which the output is produced –for
instance, more output may be associated with excessive pollution hence GDP may
overstate the level of welfare in a country.
e) Does not show how the output produced is distributed –the extent of inequality in
terms of distribution of income is also an important indicator of welfare e.g. high
GDP may not imply increase in welfare if it is associated with widening gap between
the rich and the poor.
3. ????????????

4. Income Approach:

Let GDP = Y (income generated)

Y = national income + depreciation + (indirect taxes minus subsidies)
In the current scenario:
Y = (interest income + wages + business profits + rental income) + depreciation +
(indirect business taxes – 0)
Y = (150 + 67 + 200 + 75) + 36 + (74 - 0)
Y = P602

b) Expenditure Approach:
Let GDP = AE (aggregate expenditure)
AE = personal consumption expenditure + gross private domestic investment +
government consumption and gross investment + net exports (exports – imports)
In this scenario:
AE = household consumption + gross private investment + government purchases + net
exports (X – M)
AE = 304 + 124 + 156 + 18
AE = P602
Y = AE (verified)
5. Three approaches to measuring GDP
a) Value Added or Product Approach
A method of computing GDP that measures the total value added at each stage of
production and thus eliminate the problem of double counting. Value added is calculated
as the difference between the value of goods as they leave a stage of production and the
cost of the goods as they entered that stage.

b) Expenditure approach
A method of computing GDP that measures the total amount spent on all final goods
during a given period.

c) Income Approach
A method of computing GDP that measures the income received by all factors of
production in producing final goods (wages, rents, interest, and profits) in a given period.

6. A comparison of the classical and Keynesian views on combating a recession

A recession occurs when there is a fall in real GDP in two consecutive quarters.
Classical View
The classical view is that the recession is self-correcting and there is no need for
government to take any action in trying to combat the recession. The idea is that the price
mechanism or the invisible hand will ensure that prices of factors of production adjust
and ensure that the recession is reversed. That is, in a recession, a lot of resources
including workers are unemployed hence their prices including wages fall which in turn
lowers the cost of production. Being driven by profit, firms take advantage of a fall in the
cost of production and increase their outputs by employing more resources including
workers in a bid to make more profits. As production by firms increase, so is the GDP
hence combat the recession.
 Keynesian View
Meanwhile the classical view suggest self-correction of the recession, Keynesians argue
that the process can take too long (a painful, slow adjustment process) hence there is need
for government to intervene. They further suggest that a recession is caused by lack of
sufficient aggregate demand hence advocate for the use of an expansionary fiscal policy
which involves lowering taxes and increasing government spending. For instance,
lowering taxes on personal income like wages and salaries increases disposal income of
consumers hence they demand more goods and services. As a result firms increase
production in order to make more profits hence increasing GDP which solves the
recession.
7. Theories of consumption
a) The Absolute Income Hypothesis (AIC)
The basic principle of the AIC is that the individual consumer determines the proportion or
fraction of current income that is allocated to consumption (Average Propensity to Consume
or APC) based on the absolute level of that income. According to the AIC, Other things being
held constant, an increase in absolute income results in a decrease in the proportion of that
income devoted to consumption, that is, the APC decreases as income rises.

b) The Relative Income Hypothesis (RIH)

The Relative Income Hypothesis however suggest that the family wants to keep up with
other families it identifies with. It will therefore be under pressure to own things that other
families have. As a result, the fraction of a family’s income devoted to consumption is
influenced by the level of income relative to the income of other families with which it
identifies with rather than on the level of absolute income. That is to say, it is not the level
of absolute income that determines how much a consumer devote to consumption as
suggested by the AIC but how much their neighbor devote to consumption. Therefore, the
RIH argues that a family with any given level of income will typically spend more on
consumption if it lives in a community in which income is relatively higher because of the
pressure to keep up with their neighbors.

c) The Permanent Income Hypothesis (PIC)

 Meanwhile, the AIH and RIH depend on current income in making a decision on how much
to spend on consumption. The Permanent Income Hypothesis (PIH) argues that
consumption is not influenced by current income but rather influenced by permanent
income or total wealth. According to the PIC, permanent income or total wealth is equal to
the sum of human wealth and non-human wealth. This is whereby human wealth involves
the investment in training or skill acquisition in order to get high wages (salaries) in the
future. And, non-human wealth include rentals, interest and dividend income derived from
non-human assets in the form of real property and financial assets such as shares or stocks.
Further, the PIC defined the consumption that depends on permanent income as permanent
consumption. Based on these definitions of permanent income and permanent
consumption, the PIH argues that in the long-run, permanent consumption is a constant
proportion of permanent income.

8. In equilibrium income (Y) occurs when:

Y = C + I, but C = a + BY and I = I0 hence,
Y = a + BY + I0 , but a = 250, b = 0.8 and I0 = 200 hence,
Y = 250 + 0.8Y + 200
Y - 0.8Y = 250 + 200
0.2Y = 450
Y = 2250
Therefore, equilibrium income is equal to P2250.

Equilibrium consumption: C = a + bY, where Y is the equilibrium income: Y = 2250, a =

250 and b = 0.8
Hence, C = 250 + 0.8(2250)
C = 2050
Therefore, equilibrium consumption is equal to P2050

Equilibrium saving is equal to Investment (I), therefore, equilibrium saving is equal to

P200