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(a) Calculate autonomous expenditure, the multiplier and equilibrium GDP demanded. (30 Marks)
a.) The Autonomous Expenditure is the sum of investment, government expenditure and exports, which does not vary with real GDP. (ref. 1) According to the table, the autonomous expenditure
= C+I + G+ X= 10 +17+12= £84 (billion) (fig 2)
Multiplier= 1/ 1- slope of AE= 1/1-0.72= 3.57
The equilibrium GDP demanded is when the real GDP is equal to Autonomous expenditure. Therefore, from the calculation, the equilibrium GDP demanded= £300(billion)
(b) Illustrate your answers with a Keynesian cross diagram, and explain the process by which the economy comes to equilibrium. (30 Marks)
1b.) The Keynesian cross diagram shows the two lines which represent the real GDP and the Aggregate planned Expenditure. There is usually a point of interception between the real GDP and the Aggregate planned Expenditure, which is the equilibrium expenditure. The equilibrium expenditure is a level of aggregate expenditure and real GDP at which everyone‘s spending are fulfilled. When the aggregate planned expenditure is not the same as actual aggregate expenditure, a process of convergence towards the equilibrium expenditure happens. (Ref 2)
At first, we usually have our autonomous expenditure which is planned by the government. By calculating the aggregate expenditure, we have to sum up the consumer spending with the autonomous expenditure and then minus the import. From the graph, we plotted the point (AE is at Y-axis Real GDP is at X-axis) and it became a straight line and it has a positive slope in the graph. Meanwhile, the line of actual expenditure is formed where the aggregate planned expenditure is equal to the real GDP. It formed a 45 degree angle towards the axis.
As I mentioned above, when, two lines will has a different slopes so they will meet up at a point, which is the equilibrium expenditure. However, with the different slopes of the actual expenditure the planned aggregate planned expenditure, it shows the plan is not usually going the same as the reality. For example, there are about two common situation which government or the whole economy have to face, the Real GDP exceeds planned expenditure or the planned expenditure exceeds the Real GDP. (Fig 1)By facing the real GDP exceeds the planned expenditure; it may be the case that the economy produced more products then the consumers needed. It would lead to the increase in inventory and the unplanned investment. Yet, the inventory would then start to accumulate and it will reduce the real GDP until it reaches the equilibrium point of the two lines.
On the other hand, when the planned expenditure exceeds the real GDP, it means the actual investment or consumption is less than expected. The economy will enhance more investment in order to meet up the equilibrium expenditure. (Fig 1)

(c) Consider the situation if the economy were in recession and the government applied a fiscal stimulation that stimulated output beyond potential GDP. Explain and show using appropriate graphs the possible effects upon the price level, output, interest rates, and unemployment in both the short run and the long run. (40 Marks)
c.)Recession is one of the periods in the economic cycle which states the contraction in the economy. For example, GDP, capacity utilisation, investment spending, household income and inflation fall. Meanwhile, bankruptcies and the unemployment rate rise in this period of time.
In order to deal with the recession, fiscal policy is the use of taxation and spending by the government to stablise the economy. In this case, Fiscal Stimulation is adopted which might include the increase in public spending and lower the taxation in the economy.
In Short run, an increase in government expenditure has a direct effect on aggregate demand. A tax cut influences aggregate demand by increasing disposable income and consumption expenditure. These two forms of fiscal stimulus have multiplier effect. On one hand, an increase in government expenditure means consumers or businesses can be benefited or subsidized by the money which government spent. It can increase the aggregate demand of the economy. As I mentioned, government expenditure is one of the component in the aggregate expenditure. Therefore, an increase in government expenditure will led to increase in aggregate expenditure and the real GDP. (fig3)Meanwhile, the money demand will increase as the aggregate demand rises. (fig4) On the other hand, with the reduction in taxation, such as reduction on income tax would strengthen the workers incentive and lower the cost of labour of the company. Another example is the reduction of tax in capital which reduced the wedges between the costs of borrowing and the return to lending and led to increase in aggregate supply in short term. (fig6) With rise in aggregate demand and supply, the price level and the output level will increase with the stimulation of output beyond the potential GDP.

However In long run, due to the money demand, the price level will increase and the real money supply will then decrease (fig5). With reduction in real money supply, the interest rates will go up in order to attract savings from the public. The aggregate demand will drop a bit as it is more favorable for public to save the money instead of spending (fig 7). With the increase in aggregate demand in long term, it will help improving the unemployment rate as the market demand for more output.
To conclude, with the fiscal stimulation by the government, it had impacts which affect the economy in general. By fiscal stimulus, like increase the government expenditure can increase aggregate and money demand. With increase demand it will hence lead to increase in output level. Meanwhile, price level will also rise in short term. Nevertheless, with price rises, the real money supply will fall and in order to avoid excess demand, an increase in interest rate is needed as to encourage more saving. The price level will fall but it will keep a higher price level than before in long run. With the reduction in taxation will help improving the employment in long run as aggregate demand is higher than before.
Reference:
Parkin Powell Mathews ECONOMICS (eighth edition)
Chapter 27 Expenditure Multiplier
P.643 (ref1)
p.644 (ref2)
Chapter 29 Fiscal Policy
P.704-708
http://en.wikipedia.org/wiki/Fiscal_policy http://en.wikipedia.org/wiki/Recession