(a) Y = C + I + G and C = a + cYd (Boyes & Melvin, 2008).
Where; C = Consumption, a = autonomous Consumption, cl = Marginal Propensity to consume (MPC), Yd = disposable income.
In addition, Yd = W –T; where W = Income before taxes and T = Taxes
Therefore, C = Yd + MPC (W-T)
Thus, DC = DY + MPC (W-T)
Since, DC and DW = 0,
Then, 0 = DY + 0.8 (0-T)
0 = DY + 0.8T
DY = 0.8T
DY = 0.8* $ 1 Billion
DY = $ 0.8 Billion
(b) Marginal Propensity to Consume (MPC) = 0.8
MPC = Change in Consumption / Change in equilibrium GDP
Y = C + I
DY = DC + DI
DY = kDI; where, 1-1/k = MPC (Keynes, 1936)
Thus; if 1-1/k = 0.8,
-1/k = -0.2,
k = 5
Since DY= k DI,
Then; DY = 5 ($ 1 billion)
DY = $ 5 billions
(c) It is evident that the policy of increasing equilibrium real GDP in an economy is more effective when the government has a strategy of increasing investment expenditure than increasing taxes. According to Boyes and Melvin (2008), when taxes are increased there is a small change in equilibrium real GDP. This is because consumers reduce their consumption levels when taxes are increased. The purchasing power of consumers reduces when taxes on products are increased since this causes an increase in the prices of products. Investment expenditure causes a very high increase in the equilibrium real GDP since there is an increase in employment opportunities. As investment expenditure increases, more labour units and capital is applied in the production system resulting in more income being generated within the economy. When income levels of people in an economy raises, their consumption increases. An increase in both investment expenditure and consumption leads to an increase in the equilibrium real GDP. There is a direct relationship between real GDP, investment expenditure and consumption. On the other hand, taxes cause a small change in the real GDP (Boyes & Melvin, 2008).
(a) Business confidence is a measure of performance and experiences of businesses in an economy. When business confidence falls, there is low performance of firms in the economy and this leads to reduction in the equilibrium GDP. It is important to note that when business confidence falls, the level of investment falls. According to Cottrell and Lawlor (1995) disposable income and investment have a direct relationship, that is Y = C + I + G. When business confidence falls and there is a decline in the level of investment, the gross domestic product also declines. Unemployment increases with a decrease in the equilibrium GDP levels (Holt & Pressman, 2001).
From the above diagram, there is a relationship between disposable income and consumption expenditure. Disposable income is a function of consumption expenditure, investment expenditure and government expenditure.
Keynesian economic model provides that other variables that affect the levels of equilibrium GDP are exports and imports. When a country increases its exports, more foreign exchange is obtained and this improves the equilibrium GDP. The gap between exports and imports should be managed to ensure imports do not exceed exports. When the net difference between exports and imports increases, more income is generated in a country leading to more investment opportunities. When investment expenditure increases, the level of employment also increases. However, when the gap between exports and imports decreases there is low investment in a country leading to low levels of equilibrium GDP. Employment declines when the difference between exports and imports is low (Gnos and Rochon, 2006).
From the above graph, the there is a direct relationship between disposable income and consumption expenditure. This is a 45-degree model which displays the relationship between disposable and consumption expenditure. Disposable income is affected by consumption expenditure, investment expenditure, government expenditure and net exports.
The economic meltdown that was experienced in 2007-2009 affected economic performance of many countries adversely. This resulted into a decline in the levels of investment expenditure in many countries leading to reduction in GDP. Decline in investment and GDP resulted into reduction in employment levels in many countries. The economic recession affected many sectors of the economy and this has affected many industries (Spencer, 2008). The global economic recession caused a reduction in the employment opportunities since investment opportunities were few. Business confidence declined by great margins during this period and this resulted into a severe investment environment since many investors became risk averse and reduced the amount of investment income. High levels of unemployment were experienced in all countries of the world. To reverse this trend, many international bodies intervened by establishing policies to improve economic status of different countries. For example, IMF provided loans to different governments as a measure to improve investment expenditure. Countries are recovering from the economic shock and it is estimated that in the year 2011 and 2012 many economies will have completely recovered and a positive economic growth will be experienced (The President of the United States and The Council of Economic Advisers 2010).
Australia was affected by the economic recession experienced by global economies in the recent past. Business confidence declined as a result of the low performance of most of industries and this caused a reduction on the equilibrium GDP of the country. The data provided by The Treasury displays a decline in economic performance during the years 2008 and 2009. However, the data shows a slight improvement in economic performance from the financial year 2009-2010. The Australian government has predicted that in 2011, the country will achieve an upward trend in economic performance. It is estimated that the total revenues to be collected in the financial years 2010-2011, 2011-2012, 2012-2013 and 2013-2014 will be $321,765 M., $358,094 M, $383, 009 M., and $404, 862 M. respectively (Pre-Election Economic and Fiscal Outlook, 2010). To improve business confidence in the economy, the Australian government has introduced different policies to improve government expenditure. Collaboration between government agencies and business sectors has been enhanced to create business confidence. Various polices have been adopted to improve investment as a means of increasing employment levels, for example establishment of the National Broadband Network (NBN) (Pre-Election Economic and Fiscal Outlook, 2010).
(b) Investment expenditure in the Australian government should be increased as a policy to increase the equilibrium GDP. Investment expenditure can be increased by providing more opportunities for both domestic and foreign investors to increase their investments in the country. The infrastructures in the country should be improved to allow investors pursue their goals. Business confidence should be improved by creating suitable political, social and economic climates in the country. Government expenditure should be increased to improve the equilibrium GDP. Since government expenditure is financed through taxes, the Australian government should implement a policy of increasing the taxes paid by the citizens by a small margin. An increase in the taxes will increase the level of consumption leading to an increase in the equilibrium GDP. However, care should be taken not to increase taxes by great margins since this may reduce the level of consumption leading to reduction in equilibrium GDP.
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