1. Discuss and explain what effect a reduction in the marginal propensity to consume has on the size of the multiplier. Answer:

* C = c1 + c0 YD

Marginal propensity to consume, MPC= c1

* Where C = Consumption, c0 = intercept, YD = disposable income When a reduction in marginal propensity to consume, consumer disposable income is low, consumer does not has additional dollar or ringgit to dispose, a degree of decrease in disposable income is likely to decrease in consumption. * Therefore income – YD (decreases) consumption – C (decreases)

C (consumption)

Slope = c1

Consumption Function - C = c0 + c1YD

MPC = C

YD

C

Multiplier = 1 = 1

1 – MPC 1 – c1

c0

YD

Y (disposable income)

YD C MPCMultiplier

A reduction in marginal propensity to consume will cause a reduction in the multiplier. When firms increase production in response to some initial change in demand, households will increase their consumption by a smaller amount when the MPC decrease. So, the income – included change in demand will be decreasely smaller causing a smaller multiplier effect.

2. Use the ZZ-Y model to illustrate the effects of a reduction in consumer confidence on the economy. Also explain what effect this reduction in consumer confidence has on the economy.

Answer:

Equilibrium in the goods market:

* Production (Y) = Demands (Z)

* Z(Demands) = C(consumption)+I(investment)+G(government expenditure) * C = c0+c1YD;

* c0 = intercept; c1 = marginal propensity to consume; YD = disposable income * YD = Y – T(Tax)

* Y = Z

Y = C + I + G

Y = c0+c1(Y-T) + I + G

Y = c0+c1Y – c1T + I + G

Y – c1Y = c0 – c1T + I + G

Y (1-c1) = c0 – c1T + I + G

Therefore, Y = 1 (c0 – c1T + I + G) Y (Production)

1 – c1

Z (Demand), Y (Production)

Equilibrium point: Y=Z

ZZ0

ZZ1

A

Z0

New equilibrium point

Z1 A1

Autonomous Spending

450

Y (Income)

Y1 Y0

Consumer Confidence ZZ0 Y (production) Equilibrium Output Conclusion:

The reduction in consumer confidence will cause a reduction in consumption and demand; from ZZ0 decrease to ZZ1. As demand decreases, firms will decrease or cut production. Hence, this event will cause a lower level of equilibrium output; from A0 to A1.

3. Suppose that, a given level of disposable income, consumer decide to save more. Explain what effect this decision will have on equilibrium income. Also, explain what effect this decision will have on the level of saving once the economy has reached the new equilibrium.

Answer:

* MPS = Marginal Propensity to Save

* S(saving) + T(tax)-G(government expenditure) = I(investment) * S = -c0+(1-c1)(Y-T)

* C = c0+c1YD;

* c0 = intercept; c1 = marginal propensity to consume; YD = disposable income * YD = Y(income) – T(Tax)

From:S + T – G = I

-c0 + (1-c1) (Y – T) + T – G = I

-c0 + Y – T – c1Y + c1T + T – G = I

Y (1-c1) = I + c0 – c1T + G

Y = 1 (I + c0 – c1T + G)

(1 – c1)

Multiplier = 1 = 1 .

(1 – c1) (1 – MPC)

When consumer decide to save more, it will cause multiplier to decrease, where marginal propensity to consume decrease, as consume is fall, demand will decrease, firms will cut down production, and decision on equilibrium income will decrease. MPS Multiplier MPC Z (demand) Y (production) Equilibrium Income SHIFT Downwards Multiplier = 1 = 1

1 – MPC 1 – c1

Z (Demand), Y (Production) Y...