Answer to Question #264340 in Macroeconomics for cheru

Question

a)     In an Economy, the consumers are known to consume 40% of their disposable income, while if they earned no income, they would consume commodities worth 50 million shillings. The government takes 50% of consumers’ income in form of income tax while the other sources contribute 105 million shillings to the government. The government spends 250 million shillings on its projects. The rest of the information concerning the economy is as follows:

 

i)                  Identify the endogenous variables in the models of this economy        (3 mark)

Drive the IS and LM equations for the economy described above

Answer 1

In macroeconomic models, endogenous variables are usually key macroeconomic indicators. These include indicators that characterize economic growth, unemployment, inflation, as well as some financial and monetary indicators (exchange rate, interest rate).

A reduction in government spending and tax cuts can lead to a crowding out effect that significantly reduces the effectiveness of stimulating fiscal policy.

If government spending G increases, then total spending and income increase, which leads to an increase in consumer spending C. An increase in consumption, in turn, increases the total expenses and income of the population, and with a multiplier effect. An increase in Y contributes to an increase in demand for money m), since more transactions are made in the economy. An increase in the demand for money with its fixed supply causes an increase in the interest rate R. An increase in interest rates reduces the level of investments I and net exports Xn. The drop in net exports is also associated with an increase in total income Y, which is accompanied by an increase in imports. As a result, the growth in employment and output caused by stimulating fiscal policy is partially eliminated due to the displacement of private investment and net exports.