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b).

Suppose the level of autonomous investment in an economy is 200 and the consumption
function is C=80 +0.75Y. Find the equilibrium level of income

Solution:

Y= C+I AS=AD, I = 200, C = 80 + 0.75Y

Y = 80 + 0.75Y + 200 =
Y- 0.75Y = 80 + 200 =
(1 – 0.75) Y = 280
(0.25) Y = 280
0.25 Y = 280
0.25 0.25
Y= 1,120

c). what will be the increase in national income if investment increases by 25

I = 200+25 = 225
Y=80+0.75Y+225
Y-0.75Y = 225+80
0.25Y/0.25 = 305/0.25
Y= 1220
National income = 1220 - 1120= 100
Hence increase in national Income is Sh.100

Question two
a). Suppose the level of planned investment in an economy is 200 and the savings function is
given by S=-80+0.25Y, Find equilibrium level of income

Solution
Equilibrium is achieved when two assumptions are in equal:
 Aggregate expenditure or demand = Aggregate supply or output
 Intended investment = Intended savings

Y = -80 + 0.25Y = 200

Y-0.25Y = 200 +80

0.75Y = 280
Y = 280/0.75
Y = 373.33
b). Suppose the consumption function is given by C=20+0.6Y and the following
investment function is given I=10+0.2Y find the equilibrium level of income.

Solution:
Y=C+I
Y = 20 + 0.6Y +10 +0.2Y =
Y = 0.6Y+0.2Y = 20+10
Y-0.8Y = 30
Y (1 – 0.8) = 30
0.2Y = 30
0.2 0.2
Hence Y = 150

c). given the three equations for the determination of equilibrium level of national
income, Y=C+I, C=a +b Y and I=Io .Suppose an economy has autonomous
investment of 600 and the consumption function is given by C=200+0.8Y. Find
equilibrium level of income.

Solution:
Y= C + I , C = a + b Y and I = Io.

Y = 200 +0.8 Y + 600

Y = 0.8 Y + 800
Y- 0.8Y = 800
Y ( 1- 0.8) = 800/0.2
Y = 4000

d). A hypothetical closed economy has a national income model of the form Y=C+I+G
where C =30+0.8Yand I and G and private investment and government expenditure are
exogenously determined at 50 and 80 units respectively. Compute the national equilibrium
level of income for this economy using aggregate income equals aggregate expenditure.

Solutions:

Y= C+I+G Where C = 30 + 0.8Y, I = 50, G = 80

AI = AE
Y = 30 + 0.8Y + 50 + 80 =
Y = 0.8Y + 160 =
Y- 0.8Y = 160
Y (1-0.8) = 160
Y = 160/0.2
Y = 800
Equilibrium level income = 800

e). Briefly explain the Keynesian Theory of Consumption

It states that the aggregate real consumption expenditure of an economy is a function of real
national income. The Keynesian theory of consumption tells that consumption rises with income.
This relationship between consumption and income is central to Keynes‘s model of the economy.
While Keynes recognize many factors include wealth and interest rate plays a greater role in
determining consumption level in the economy.

Keynes stated that the rate of interest may have some influence on consumption but the real income
was the important determinant of consumption.
The classical economists used to argue that consumption was a function of the rate f interest such
that as the rate of interest increased, the consumption expenditure decreased and vice versa.
Question Three
a). Given a hypothetical four-sector economy model such that
Y = C + I + G + (X - M) and that C = α + βYd and M = M0 + K(Y)
Y = output level
T = Lump sum tax
I = Investment
G = Government spending
(i). Describe the meaning of α, Yd and β terms as used above

α, is autonomous consumption expenditures which do not depend on the level of national income
(independent).
Yͩ is disposable income which remains after taxations. Income that remains after consumers have
received transfer from the government and paid taxes. It can use for consumption or to save.
β, is marginal propensity to consume which refers to the change in the consumption that arises
from additional unit of income.

a). Given that

I = 300; G = 400; T = 200; X = 100, α = 500; β = 0.60; M0 = 50 and K = 0.40

Calculate
(i). National income at equilibrium (Y)
Y = C+I+G+[x-m]
Y = 500+0.6[Y-200]+300+400+[100-50+0.4]
Y = 1200+0.6Y-120+50-0.4Y
Y = 1130+0.6Y-0.8Y
Y = 5650
(ii). Consumption (C)
C = a+bY ͩ
C = 500+0.6[5650-200]
C = 3770

(iii). Imports (M)

M = Imports
M = Mo+K[Y]
M = 50+0.4
Therefore, Imports = 2310

a). Discuss the quantity interpretation of LM-curve

LM curve is a curve that joins various combination of income and interest rate at which monetary
sector that is money market is in equilibrium. It is possible to derive the LM curve by adopting the
quantity theory approach. The quantity of exchange MV = PY gives us the equilibrium condition of
the money market. If V is assumed to remain constant, the equation is converted into the quantity
theory of money.
The assumption implies that for any given price level, P this supply of money, M is determined by
the level of income Y.
dM dV dP dY
+ = +
M V P Y
Therefore the slope of the LM curve is positive. At all the point s along the curve, the
demand for the money is equal to the supply of money. For instance rising in the
interest rate must be accompanied by a rise in national income.

Question four 1 1
Money demand and money supply is given by (M/P) d = 1000r and (M/P)S=1000 and the price
level is 2
a). Graph the supply and demand for real money balances

r
(M/P)s
1

0.5

(M/P)d

500
M/P

The downward sloping line represents the money demand function, which is 1000 r.
With M = 1000 and P = 2, the real money supply is 500. The real money supply is
independent of the interest rate and is, therefore, represented by the vertical line.
b). what is equilibrium interest rate?

Equilibrium interest rate is the rate at which the supply for money meets its demand. It is
used by the central bank. It tied the demand and the supply of money. It occurs at the
point where the demand for a particular amount of money equal to the supply of Money.
Set the supply and demand for real balances equal to each other:

500 = 1000r
r = 0.5, so the real interest rate is 0. 5%

c). Assume the price level is fixed. What happens to equilibrium interest rate if the supply
of money is raised from 100 to 1200

With an increase in money supply from 100 to 12000, the new supply of real balances
is 14000. We can solve for the new equilibrium by once again setting demand equal
to supply:

14000 = 1000 r
r = 14.

d). If the central bank was to raise the interest rate to 7% what money supply should it
set?

In equilibrium, M/P = 1000 r. Setting the price level at 2 and substituting r = 7, we

find:

M/2 = 1000 *7
M = 14000.
Thus the bank must increase the nominal money supply from 100 to 14000.