1990-2007 AL-Econ-Macro-Past Paper (Sorted by Topics)

The Keynesian Model

2008-AL-ECON-II Past Questions on Macroeconomics

Prepared by A.Chow

Unit 1 National Income Accounting1. Which of the following are included in the national income of Hong Kong?(1) government spending on public assistance.

(2) commission from the sale of second-hand cars.

(3) salaries of the employee of the Jockey Club.

(4) receipts form the sale of stocks and shares.

A. (1) and (2) only

B. (1) and (4) only

C. (2) and (3) only

D. (3) and (4) only (90-01)

Refer to the following national income statistics of a hypothetical economy.

($ billion)

Consumers expenditure

1150

Government final consumption

380

Gross domestic fixed capital formation

340

Value of physical increase in stocks and work in progress

30

Exports of goods and services

550

Imports of goods and services

540

Net property income from abroad

10

Taxes on expenditure

300

Subsidies on production units

40

Capital consumption

220

2. The gross national product at market prices isA. $1 880 billion.

B. $1 920 billion.

C. $2 140 billion.

D. $2 400 billion. (91-11)

3. The difference between national income at market prices and national income at factor cost isA. $220 billion.

B. $260 billion.

C. $300 billion.

D. $340 billion. (91-12)4. Below are the national income statistics of an economy in a certain year:

$ million

Wages

60

Rent

50

Depreciation

30

Interest

25

Expenditure taxes

20

Dividend

15

Subsidies

11

Retained profits

10

Profits tax

8The amount of national income at factor cost isA. $159 million.

B. $160 million.

C. $168 million.

D. $177 million. (92-14)

5. Which of the following items should be excluded from GNP at market prices in order to calculate disposable personal income?(1) indirect business taxes

(2) income tax

(3) retained earnings

(4) transfer payments

(5) subsidies

A. (1), (2) and (3) only

B. (1), (2) and (4) only

C. (1), (3) and (5) only

D. (2), (4) and (5) only (93-01)

6. Consider a closed economy with expenditure given by:

C=1,000

(Consumption)

I=400

(Investment)

G=200

(Government Expenditure)

Ta=100

(Tax)

Tr=50

(Transfer Payment)The gross national product of the economy is A. 1,450

B. 1,500

C. 1,550

D. 1,600 (94-29)

7. Which of the following statements is/are correct?(1) Gross national product (GNP) is always larger than net national product.

(2) GNP is always larger than gross domestic product (GDP).

(3) GNP at current market prices is always larger than GNP at constant market price.

A. (1) only

B. (1) and (2) only

C. (1) and (3) only

D. (1), (2) and (3) (95-01)8.

GDP Components$ billion

Private consumption expenditure


Government consumption expenditure

Capital consumption allowances

Indirect taxes

Subsidies

Net export o goods and services

Net income from abroad20

8

10

2

3

4

-3

6

Refer to the above table. The GNP at factor cost (in billion $) isA. 36.

B. 41.

C. 42.

D. 44. (95-02)9. Which of the following transactions is regarded as investment in the national income accounts?A. The Hong Kong Cultural Centre buys a painting of the 18th century for $5 million.

B. You buy 10,000 shares of Hong Kong Telecom stock.

C. Your father buys a newly constructed flat for $7 million.

D. All of the above. (96-05)10. Suppose gross national product increases but gross domestic product falls. Then the net income from abroadA. is negative.

B. is positive.

C. increases.

D. decreases. (96-06)11. Real gross domestic product is NOT a good measure of the welfare of a country because it does not take into account(1) the population size.

(2) non-market transactions.

(3) the change in the price level.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (96-28)12. Study the following information of an economy:

$ million

Consumption expenditure

2,000

Indirect tax

1,200


1,000

Depreciation

300

Gross national product

6,300

Subsidies

200What is the net national product at factor costs?

A. $3,300m

B. $4,300m

C. $5,000m

D. $7,100m (97-27)13. Gross Domestic Product (GDP) Complements $ billion


50


30

Net domestic fixed capital formation

20

Increase in inventory

5

Depreciation

10

Indirect taxes

4

Subsidies

3

Net exports

15

Net profit

12

Profits tax

6

Refer to the above table. The GDP at factor cost (in billion $) isA. 119

B. 123

C. 129

D. 150 (98-24)14. Refer to the table below.

Gross Domestic Product (GDP) Complements $ billion


160


60


20


5

Depreciation

4

Indirect taxes

8

Subsidies

2

Net exports of goods and services

40

Net income from abroad

-10The net national product at factor cost (in billion $) isA. 265

B. 275

C. 277

D. 285 (00-07)15. Country X imports workers from other countries but does not export any workers to other countries. Suppose the gross domestic product (GDP) of country X is $280 billion. If imported workers earn $80 billion and they remit $60 billion of their income to their home countries, the GNP (in billion $) of country X isA. 140

B. 200

C. 220

D. 260 (00-25)16.

Gross National Product (GNP) Components$ billion




Capital consumption allowances

Indirect taxes

Subsidies

Net exports of goods and services


10

12

4

2

3

-6

-4

Refer to the above table. The GNP at factor cost (in $ billion) isA. 42

B. 43

C. 46

D. 50 (01-07)17. Refer to the table below:

Gross National Product (GNP) Components$ billion





Depreciation

Net exports

Indirect taxes

Subsidies


X

40

10

20

5

30

15

8

If net national product at factor cost is $140 billion, the value of X is

A. 10

B. 12

C. 20

D. 28 (02-01)

18. If the growth rate of per-capita real Gross Domestic Product (GDP) is greater than that of the real GDP as well as that of the per-capita nominal GDP, we can conclude thatA. both the population and the general price level have fallen.

B. the growth rate of population is higher than that of real output and the standard of living has fallen.

C. the growth rate of population is lower than that of real output and the standard of living has risen.

D. the inflation rate is greater than the growth rate of real output. (02-02)

19. Which of the following statements about gross domestic product (GDP) is/are correct?(1) Real GDP is always equal to nominal GDP in the base year.

(2) Everyone is worse off when the growth rate of real GDP is negative.

(3) When the growth rate of nominal GDP is greater than the inflation rate, real GDP decreases.

A. (1) only

B. (1) and (2) only

C. (2) and (3) only

D. (1), (2) and (3) (03-01)20. The word gross in the gross national product indicates that no deduction has been made for A. exports and imports.

B. capital consumption allowance.

C. profits tax.

D. a change in inventories. (03-07)

21.

Gross Domestic Product (GDP) Components$ billion




Change in inventory

Total exports

Total imports300

50

40

-20

80

120

Which of the following statements about the above table is correct?A. The balance of payments is not balanced because the total export value is different from the total import value.

B. The value of total market transactions in the economy is $330 billion.

C. There is insufficient data in the table to reflect the living standard of the people in the economy.

D. If $50 billion of sales tax is imposed in the economy, the value of GDP at factor costs will be $280 billion. (04-02)

22. In an economy the growth rate of nominal GDP is positive and falling while the population growth rate and the inflation rate are both negative. It means thatA. both per capita nominal GDP and real GDP are rising.

B. the growth rate of real GDP must be rising.

C. the per capita real GDP must be falling.

D. the fall in nominal GDP growth rate will lead to a fall in aggregate demand. (04-02)

23. Consider the following information on an economy:

Growth rate

(relative to previous year) (%)

Year 1Year 2

Nominal gross domestic product (Nominal GDP)-30

General Price Level-4-2

Population2-1

Which of the following about the economy is FLASE?A. The nominal GDP in the above two years is the same.

B. The real output increases in year 2.

C. The general price level is decreasing at a decreasing rate.

D. The per capita real GDP decreases in year 2. (05-03)

MC Answers on National Income Accounting

CBBCADACCCACCABBBAABCADNational Income Accounting1992 Q. 1

As measure of welfare, GNP tends to overstate that of the newly industrialized countries and understate that of the less developed countries. Explain. (12 marks)GNP accounts do not include non-market transactions. For example, housewives services are not counted. As a country develops, there will be a higher of labour specialization. The ratio of market to non-market transactions will also rise. Less developed countries tend to have proportionally bigger non-market sectors as compared to newly industrialized countries, therefore, the measured GNP tend to understate the welfare of the less developed countries.

Also it is assumed that market prices approximate the social value of output. Measured GNP overstates the social value of output of negative externalities (such as pollution) exist but they are not included in the private costs. Because newly industrialized countries tend to have proportionally more production with negative externalities, their measured GNP tends to overstate their welfare.

1999 Q. 5

(a) Define Gross domestic product (GDP) and gross national product (GNP) and explain their difference in an open economy. Must the economy be closed for GDP to equal GNP? (5 marks)

GDP can be defined a measure of the total market value of final goods and services of all resident producing units of a country or territory in a specified period, before deducting allowance for consumption of fixed capital.

By resident producing units, we mean all producing units which based their major economic activities within the territory, thus the actual production activities may take place within or outside the territory of the economy and the factors may be supplied by domestic residents or non-residents.

By GNP, we mean the total market value of final goods and services produced by the citizens, or residents, of a country within a period of time, usually a year.

By residents, we mean all individuals who normally stay in the territory of an economy or all producing units which based their major economic activities within the territory.

The difference between the two is net factor income from abroad. As the market value of production by both residents and non-residents is included in GDP, only the income earned by residents from production is counted in the GNP. Moreover, the earnings of residents from various economic activities without or outside the territory are included in GNP, whereas earnings of non-residents from economic activities within the territory are excluded. To find out the difference between the factor income earned by residents from outside the economic territory and the factor income earned by non-residents from within the economic territory, we can obtain the net factor income from abroad. In an open economy, if it is positive, then GDP will be smaller than GNP, while if it is negative, then GDP will be greater than GNP. However, if net factor income from abroad is zero, this means that the foreign-source income earned by domestically owned factor is exactly offset by the domestic-source income earned by foreign-owned factors, and then GDP will be equal to GNP even in an open economy.

(b) Suppose the working population in an open economy consists of both domestic short-term (say, with less than one year of residence) imported workers. While the latter contributes to the output of the economy, they regularly remit part of their income earned in the economy back to their home countries.

(i) If these imported workers do NOT create unemployment for domestic workers, how will the presence of these imported workers affect the GDP and GNP of this labour-importing country? (5 marks)

In the absence of worker displacement, GDP will necessarily rise as long as all these imported workers are productive. If the imported workers contribute more or less to GDP than what they take out in the form of wage payments, i.e. their marginal productivity is higher than their wage; the economys GDP will rise or fall. Hence, as long as the total wage paid to these imported workers is no higher than their total marginal productivity, then they will contribute more to the economys GDP than they take out in the form of wage income. In this case even if they remit 100% of their income earned in the economy back to their home countries, the economys GNP will rises as the economys GDP rises as a result of labour importation.

(ii) If these imported workers create unemployment for some domestic workers, how will the presence of these imported workers affect the GDP of this labour-importing country? In particular, how does your answer depend on whether the productivity of these imported workers is higher than that of those domestic workers they replace?

(2 marks)

In the presence of worker displacement, how the countrys GDP will be affected depends on whether the productivity of these imported workers is higher than that of these domestic workers hey replace. If these imported workers are more productive than those domestic workers they replace, the countrys GDP will rise. If these imported workers are less productive than those domestic workers they replace, the countrys GDP will fall. Lastly, if the productivity of these imported workers and those domestic workers they replace are the same, then the countrys GDP will be the same.

2004 Q. 1

Name one similarity and one difference between each pair of the following terms.

(a) National income; national product. (3 marks)

The similarity is the measure of aggregate productivity activity in an economy over a certain period of time. The difference is the sum of incomes of various factors of production at the cost level (NNP at factor cost) Vs sum of values of final goods at the sale level (GNP or NNP at market price).

2006 Q. 1

State whether each of the following statement is true, false or uncertain. Briefly explain your answer. (5 marks)

(a) In the absence of taxes (when the producers receive/ pay exactly what the households pay/ receive), there is no difference between national product and national income.This statement is Uncertain. It depends on whether the concept of national product is gross or net. In the absence of indirect business taxes (IBT) and net subsidies to enterprises, national income (NI, valuation of these goods and factor cost, also called NNP at factor cost) equals net national product (NNP, valuation of these goods and services at market prices). But since gross national product (GNP) equals the sum of net national product and capital consumption allowance (CCA. or depreciation), NI = GNP only there is no capital depreciation.- END -Unit 2 - The Keynesian Model(i) Two-sector National Income Model

1. In a hypothetical closed economy,

C=50 + 0.8Y

whereC=consumption expenditure

I=20

Y=national income

Y=10N

I=investment expenditure

N=employed labour force

If the total labour force is 50, how much will the government have to spend so that national income will reach its full employment level?A. 30

B. 150

C. 350

D. 500 (90-02)

2. In a closed economy without government, consumption rises by $40 million when national income rises by $100 million. This shows that(1) the marginal propensity to consume is 0.4.

(2) savings will rise as national income rises.

(3) the average propensity to save is 0.6.

(4) investment increases as national income increases.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (4) only

D. (3) and (4) only (91-01)

3.

From the above graph, the value of the multiplier is equal toA. PQ / ST

B. PQ / TQ

C. ST / RT

D. ST / PQ (93-09)

4. Refer to the following diagram of a closed economy with no government sector.

Which of the following are true?(1) Saving must be negative when income is less than Y1.

(2) The average propensity to save is one at Y1.

(3) The vertical distance between C and AE at Y2 represents saving at Y2.

(4) There is an unintended reduction in inventory at Y3.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (4) only

D. (3) and (4) only (93-14)

5.

A shift of the saving curve from S1 to S2 implies that(1) the marginal propensity to consume has decreased.

(2) the autonomous consumption expenditure has increased.

(3) at each disposable income level, the average propensity to consume has increased.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (94-04)

6.

Which of the following statements about an elementary Keynesian model without government and external trade is correct?A. At Y2, the economy is at full employment.

B. At Y1, the stock of the economy will increase.

C. At Y3, there will be an unintended increase in stock.

D. At Y1, realized saving is greater than realized investment. (94-06)

7.

The above diagram shows the consumption function of an economy. Which of the following statements are correct?(1) The marginal propensity to consume is equal o the average propensity to consume.

(2) The average propensity to consume is equal to the average propensity to save.

(3) The marginal propensity to consume is greater than the marginal propensity to save.

(4) The average propensity to consume and marginal propensity to save are constant.

A. (1) and (2) only

B. (1) and (4) only

C. (2) and (3) only

D. (2) and (4) only (95-03)

8. Which of the following statements is true?A. If the national income is $120 billion and the consumption is $96 billion, the marginal propensity to consume is 0.8.

B. The slope of the investment function is equal to the slope of the saving function when the national income is at its equilibrium level.

C. The average propensity to consume is determined by the slope of the consumption function.

D. The marginal propensity to consume is determined by the slope of consumption function. (95-05)

9. Suppose the national income (Y) is 1,000. The consumption function and the investment function are C = 100 + 0.8Y and I = 80 respectively. Then, the realized investment is _____ and the unplanned inventory investment is _____.A. 100 20

B. 80 20

C. 80 0

D. 100 0 (95-06)10. Given C = 20 + 0.75Y, where C is consumption and Y is income, which of the following statements are correct?(1)Marginal propensity to consume is smaller than average propensity to consume.

(2) Marginal propensity to consume is constant.

(3) Average propensity to save is less than 0.25.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (96-07)11. Money Income ($mn) Monthly consumption expenditure ($mn)

40

40

45

43

50

46

55

49When the monthly income increases from $40mn to $50mn,(1) the average propensity to consume decreases.

(2) the marginal propensity to save is constant.

(3) the marginal propensity to consume is smaller than the marginal propensity to save.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (97-03)

12.

In the above diagram, the marginal propensity to save is equal to

A. BD / GH

B. DE / GH

C. BD / OH

D. BE / OH (97-05)

13. Consider the following model:

C=10 + 0.6Y

C=consumption

I=a

I=investment

Y=4L

Y=national income

L=labour employment

Suppose there are 50 units of labour. At full employment, a equal toA. 70

B. 100

C. 120

D. 150 (98-01)

14.

The diagram below shows the aggregate expenditure in a closed economy without taxes. At the equilibrium income level, the average propensity to save is given by the ratioA. PQ / OR

B. QR / OU

C. ST / OU

D. SU / OU (99-01)

15. In an elementary closed economy Keynesian model without a government, investment is fixed at some level. Suppose the equilibrium level of income increases as a result of an increase in the marginal propensity to consume, then the equilibrium level of saving willA. increase.

B. decrease.

C. remain constant.

D. be indeterminate. (99-09)

16.

Suppose the consumption curve shifts from C1 to C2. We can conclude thatA. the equilibrium national income will increase.

B. the marginal propensity to save has decreased.

C. the average propensity to save has increased.

D. the average propensity to consume has increased. (00-01)

17. The following table shows how the consumption expenditure is related to the income of a closed economy without a government.Consumption Expenditure60160240300340360

Income0100200300400500

Suppose the planned investment is 60 and the planned consumption is always realized. Which of the following statements is correct?A. The average propensity to consume increases as the income increases.

B. The equilibrium income is 300.

C. The amount of unrealized investment is 40 when the income is 200.

D. The amount of unplanned investment is 80 when the income is 500. (00-03)Answer questions 18 and 19 with reference to the diagram below.

18. At the equilibrium income level, the average propensity to consume is _____ and the marginal propensity to consume is _____.A. 0.4 0.6

B. 0.6 0.C. 0.6 0.8

D. 0.8 0.6 (01-04)

19. What will be the new equilibrium income if investment increases by 100?A. 1 100

B. 1 250

C. 1 500

D. 2 000 (01-05)

20. Consider the following diagram:

Which of the following are true at Y1?(1) Unplanned investment is greater than zero.

(2) Realized saving is larger than realized investment.

(3) Inventory increases.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (01-10)

21. Consider the following diagram:

Which of the following can explain the shift in the consumption curve from C1 to C2 in the above diagram?

A. a fall in marginal propensity to save together with a rise in lump sum income tax.

B. a rise in proportional income tax rate together with a fall in autonomous consumption.

C. a fall in marginal propensity to consume together with a cut in lump sum income tax.

D. a fall in proportional income tax rate together with a rise in autonomous consumption. (02-06)

22. The table below shows the consumption function of an economy.Disposable income ($)0100200300400500

Consumption Expenditure ($)100180150300340370

Which of the following statements is correct?A. The level of saving decreases as disposable income increases.

B. The marginal propensity to save increases as disposable income increases.

C. The average propensity to save decreases as disposable income increases.

D. The marginal propensity to consume is greater than the average propensity to consume when disposable income is below 300. (02-08)23. Refer to the following diagram. Assume there is no government or foreign trade.

We can conclude from the above diagram thatA. the average propensity to consume is greater than the marginal propensity to consume.

B. saving is zero if national income is equal to 100.

C. the equilibrium income is 200.

D. there is an unintended increase in inventories when national income is 300. (03-03)

24. Refer to the following data of a closed economy without the government sector.Investment

expenditureConsumption

expenditureNational income

150

150

150

150

150100

175

250

325

400100

200

300

400

500

An increase in investment expenditure of 50 will raise both equilibrium income and consumption expenditure by _____ and _____ respectively.A. 100 ... 50

B. 150 ... 100

C. 200 ... 150

D. 200 ... 200 (03-05)

25. Refer to following diagram of the consumption function in an economy.

Which of the following statements about the consumption function is correct?A. When disposable income is below Y1, marginal propensity to consume is smaller than average propensity to consume.

B. When disposable income is above Y1, marginal propensity to consume is equal to average propensity too consume.

C. The average propensity to save is always equal to the marginal propensity to save.

D. The marginal propensity to save increases as disposable income rises from a level below Y1 to a level above Y1. (04-03)

26. In a closed economy, the balanced budget multiplier is smaller than one whenA. there is no induced consumption in the economy.

B. the marginal propensity to invest is greater than zero.

C. the marginal propensity to consume falls by 10%.

D. None of the above. (04-05)

27.

Consider a two-sector model with exogenous investment function. Suppose the expenditure function in the economy changes from E1 to E2. Which of the following statements about the economy is FLASE?A. The marginal propensity to consume is constant at 0.8.

B. The amount of autonomous dissaving increases by 20.

C. The equilibrium level of saving decreases by 20.

D. The average propensity to consume at every level of national income increases. (05-02)

28. Which of the following statements about the marginal propensity to save is correct?A. The marginal propensity to save is always smaller than the average propensity to save at all levels of national income.

B. The magnitude of marginal propensity to save affects the effectiveness of fiscal policy.

C. The magnitude of marginal propensity to save does not affect the effectiveness of monetary policy.

D. The sum of marginal propensity to save and average propensity to consume is always equal to 1.

(05-09)29. Unintended inventory investmentA. is not included in gross domestic product (GDP).

B. is gross investment minus capital consumption allowances.

C. can be either positive and negative.

D. is zero when actual aggregate expenditure equals total output. (06-02)

30. In an elementary Keynesian model, an excess supply of goods will lead toA. rising interest rate.

B. falling unemployment.

C. falling output.

D. falling nominal wages. (06-05)

31. The above diagram shows a closed-economy elementary Keynesian model in which there is no government sector and investment is autonomous. Suppose the aggregate expenditure function changes from E1 to E2 due to a change in the marginal propensity to consume. Which of the following is FALSE?

A. The equilibrium level of income doubles.

B. The marginal propensity to consume doubles.

C. The equilibrium level of saving decreases.

D. The amount of autonomous saving remains unchanged. (07-01)

MC Answers on Two-sector National Income Model

(i) Two-sector National Income Model

1989 Q. 3

Consider a simple Keynesian closed economy without tax and government expenditure. The consumption function (C) is given as:

C=$50 million + 0.75Y

Where Y is the aggregate output. Suppose firms plan to invest $80 million and the full-employment output capacity is $400 million.

(a) If planned consumption is realized, what is the amount of unrealized investment?

(5 marks)

In a closed economy, the sources of demand come from consumption and investments. So at equilibrium Y = C + I.

If C = $50 million + 0.75Y and I = $80 million, to satisfy all demand the equilibrium income should be equal to

Y=50 + 0.75Y + 80

0.25Y=130

Y=520

However, since the full-employment output is only $400 million, if planned consumption is realized, consumption demand will be equal to 50 + 400(0.75) = 350 million. This means that only 50 million is left for investment. Thus the amount of unrealized investment will be equal to

$80 million $50 million= $30 million(b) Explain how the introduction of taxes can help the planned investment to be fully realized. (5 marks)

With the introduction of taxes, the disposable income of the households will fall. Since the amount of consumption is directly related to the amount of disposable income a household possesses, the level of consumption demand will fall. As there is a fall in consumption demand, the amount of resources needed to produce consumption goods will also become smaller. Thus, more resources can be released to the production of investment goods and the planned investment will eventually be fully realized.

1990 Q. 2

Thriftiness, while a virtue for the individual, is disastrous for an economy which is not fully employed. Explain this statement, with the aid of a diagram. (10 marks)

This statement is the Paradox of Thrift proposed by Keynes. There are two key considerations in the Paradox of Thrift. One is the fallacy of composition, i.e., what is good for each person separately need not be always good for all: under some circumstances, private prudence may be bad to the society as a whole. The second clue to the paradox lies in the question of whether the economy is depressed or not.

If people save more, more would be available for capital formation. However, in the extreme Keynesian model, investment and saving are independent. This means that with an increase in saving at the initial income level, the level of investment remains unchanged. If the economy is experiencing unemployment, collective increase in saving will leaf to excess supply of output at the initial equilibrium level. As a result, there will be a contraction in output so as to restore equilibrium. Eventually an intention ot save more will only result in a fall in employment as well as output but no change in saving as investment remains constant.

1991 Q. 7

(a) What is the Consumption function? Use a diagram to explain the marginal propensity to consume. (10 marks)

Consumption function is defined as the relationship between total consumer expenditure and total disposable income in the economy.

The marginal propensity to consume (MPC) is the ratio of the change in consumption (C) to the change in disposable income (Yd), or MPC = C / Yd. If the consumption is linear, then MPC is simply its slope. If the consumption function is non-linear, then MPC is the slope of its tangent.

(b) Distinguish between a movement along the consumption function and a shift of the function. Briefly explain THREE main factors that cause a shift of the consumption function. (15 marks)

Given the consumption function, if there is a change in disposable income, the amount of consumption will change. This is reflected by a movement along the same consumption function.

However, consumption is influenced by variables or factors other than disposable income. When these variables change, the whole consumption function will shift.

Factors that cause a shift of the consumption function are mainly:

Wealth: If other things being equal, differences or change in wealth clearly will influence consumption. For example, if A and B have the same income, but A has inherited wealth B has none, then As consumption will be much higher. Income distribution: Other things being equal, with a more even distribution of income, the aggregate consumption will increase. It is because wealthy people tend to save more.

Terms of credit: Other things being equal, changes in terms of credit will affect consumption, especially of durable goods. Thus if banks lower their lending rates, or relax their terms of repayment, consumption expenditure will increase.

Existing stocks of durable goods: Other things being equal, purchases of durable goods, unlike nondurable goods, can be postponed. Hence, the larger the existing stocks of durables, the lower the aggregate consumption is likely to be.

Price expectations: Other things being equal, the stronger the expectations about future inflation, the greater will be current purchases of durable goods.

1998 Q. 3

In an elementary Keynesian closed model without a government sector, investment is $100. Suppose the equilibrium level of income increases by $10 as a result of an increase in the marginal propensity to consume. Explain how each of the following will change.

(a) the equilibrium level of saving. (4 marks)

In an elementary Keynesian closed model without a government sector, at equilibrium level of income, investment must equal to saving. Hence, with an increase in the marginal propensity to consume, the equilibrium level of income increases by $10. However, since the level of investment is still $100, the equilibrium level of saving will also be $100. Thus, there will be no change in the equilibrium level of saving.

(b) the equilibrium level of consumption. (4 marks)

Since aggregate demand consists of consumption demand and investment demand, at equilibrium, Y = C + I. With the increase in marginal propensity to consume, the equilibrium income rises by $10. Since the investment is fixed at $100, the equilibrium level of consumption will undoubtedly rise. Moreover, the rise in equilibrium level of consumption will be equal to the rise in income, which is equal to $10.

2000 Q. 7

Consider the following Keynesian model:

C=A + 0.8Y whereY=national income

I=200 C=consumption

Labour supply =500 I=investment

A is a constant

Each unit of labour can produce 3 units of goods. Suppose A is 100.

(a) What is the value of the investment multiplier? (1 mark)

Ki = 1 / (1-c)

= 1 / (1-0.8)

= 5(b) Describe the employment situation of the economy. (3 marks)

Ye = C + I

= 100 + 0.8Y +200

0.2Y = 300

Ye = 1500Yf = 500 x 3

= 1500

Since the economys equilibrium level of income is equal to the full employment income, the economy is at a state of full employment.

(c) Suppose both A and the labour supply increase by 10 units.

(i) Describe the employment situation of the economy. (3 marks)

Ye = C + I

= 110 + 0.8Y +200

0.2Y = 310

Ye = 1550Yf = 510 x 3

= 1530

Since the equilibrium income is greater than the full employment income, the economy is in a state of over-full employment and there will be an excess demand for labour and inflationary pressure may arise.

(ii) By how much must the labour productivity increase in order to solve the problem faced by the economy? (2 marks)

If the full employment income can rise to 1550, the problem of over-full employment can be solved. With 510 labour, if each labour can produce1550 / 510 = 3.039 units, then the problem can be solved.

To achieve this, the labour productivity must increase by [(3.039 - 3) / 3] x 100% = 1.3%

(ii)Suppose the labour productivity increases by 10%. Describe the employment situation of the economy. (2 marks)

If the labour productivity increases by 10%, each labour can produce 3.3 units. Then the full employment income will become510 x 3.3 = 1683.

Since the full employment income is greater than the equilibrium income, there will be excess supply of labour and unemployment will exist.

(d) Based on the result in (c), explain what problems the economy may face if the aggregate demand, the labour supply and the labour productivity increase simultaneously. (2 marks)

If the aggregate demand, the labour supply and the labour productivity increase simultaneously, what problems the economy may face depends on the relative strength of the above three changes.

If the percentage increase in the aggregate demand is greater than the percentage increase of the labour supply and the labour productivity, then there will be an excess demand for goods and inflationary pressure may arise.

On the other hand, if the percentage increase in the aggregate demand is smaller than the percentage increase of the labour supply and the labour productivity, then there will be an excess supply of labour and unemployment problem will exist.

2001 Q. 1

Use the elementary Keynesian model to answer this question. Assume there is no government and no external trade.

(a) Show, with the help of a diagram, how the equilibrium level of income is determined. (3 marks)

With no government and external trade, the sources of expenditure will only consist of consumption expenditure and investment expenditure. Hence, equilibrium income can be attained when

Ye = C + I

From the following diagram, we can see that AE is equal to the summation of consumption expenditure and investment expenditure. With consumption expenditure as a function of income and investment expenditure as autonomous, equilibrium income can be attained when the AE function cuts the 45 line, showing that AE is equal to output.

(b) With the help of a diagram, explain the impact of an increase in the marginal propensity to save on the equilibrium level of income and the equilibrium level of saving. (5 marks)

With an increase in the marginal propensity to save, the slope of the saving function will become steeper, thus there will be unintended inventory at the original equilibrium income. To restore equilibrium there will be a contraction of output. As a result the equilibrium level of income will fall.

Since at equilibrium the level of planned saving equals to the level of planned investment, as investment is independent of the level of income, it remains the same even there is a fall ion equilibrium income. Thus, although there is an increase in the marginal propensity to save, the equilibrium level of saving will remain unchanged.

- END -

(ii) Three-sector National Income Model

1. An expansionary fiscal policy will be less effective ifA. the country has a low marginal propensity to import.

B. interest rates are rigid due to institutional and legal restrictions.

C. there is considerable unemployment.

D. households respond to a temporary rise in disposable income by reducing their marginal propensity to consume. (90-05)

2. Discretionary fiscal policy which increases the budgetary surplus has the same effect upon the equilibrium as doesA. an increase in saving.

B. an increase in investment.

C. an increase in private consumption.

D. a decrease in imports. (92-03)

3. Financing government spending by increasing taxation is the preferred method whenA. the interest rate is low.

B. corporate profits are low.

C. the economy is experiencing inflation.

D. the economy is experiencing a recession. (92-06)

4. The marginal propensity to consume out of disposable income of an economy is 0.8 and there is proportional tax of 15% on income. What is the value of the tax multiplier in this economy?A.-2.5

B.-2.86

C.-3.125

D.-5 (92-10)

5. If the government collects a lump-sum tax of $15 and gives an unemployment benefit of $10, what will be the equilibrium level of income?A. $400

B. $440

C. $480

D. $500 (92-11)

6. Which of the following are examples of built-in stabilizers?(1) the recurrent expenditure on education

(2) the unemployment allowance

(3) the allowance for the aged

(4) the progressive tax system

A.(1) and (2) only

B.(1) and (3) only

C.(2) and (4) only

D.(3) and (4) only (93-07)

For the question No. 7 and 8, refer to the following equations which describe a hypothetical economy.

C=150 + 0.8Y


I=100 + 0.1Y

Y=income

G=50


G=government expenditure7. If the government expenditure increases by 1, the income of the economy will increase byA.1

B.5

C.8

D.10 (94-01)

8. Suppose the production function of the economy is:

Y=10NWhere N is labour employment. If the labour supply is 400, which of the following statements is correct?A.There is an excess demand for labour.

B.There is am excess supply of labour.

C.The equilibrium income is equal to the full employment income.

D.The equilibrium income cannot be determined with the given information. (94-02)

9. After the imposition of a proportional income tax, the after-tax consumption curve would _____ the before-tax consumption curve.A. be steeper than

B. be flatter than

C. be parallel to

D. coincide with (94-07)

10. The existence of a deflationary gap indicates that(1) the equilibrium income is below the full employment income.

(2) a surplus budget should be used to eliminate the gap.

(3) the economy has insufficient aggregate demand to achieve full employment.

(4) the real income is smaller than the nominal income.

A. (1) and (3) only

B. (1) and (4) only

C. (2) and (3) only

D. (2) and (4) only (94-09)


C=200 + 0.6Yd

C=consumption

I=100 + 0.2Y

I=investment

T=0.1Y

T=tax

G=10

G=government expenditure

Y=income

Yd=disposable incomeThe government expenditure multiplier isA. 1.66

B. 2.17

C. 3.85

D. 4.26 (96-01)12. What will be the result of a fall in the marginal propensity to consume?(1)a smaller government expenditure multiplier.

(2) a contractionary effect on the economy.

(3) a fall in the government tax revenue under a proportional tax system.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (96-04)13. Suppose a government reduces its expenditure on goods and services and at the same time increases its transfer payments to the public by the same amount, thenA. the government expenditure multiplier would become smaller.

B. aggregate expenditure would remain unchanged.

C. national income would decrease.

D. national income would increase with a government expenditure multiplier of 1. (97-04)

14. Study the following information of an economy:

C=200 + 0.6Yd

C=consumption expenditure

I=75 + 0.15Y


T=100

T=taxation

G=100


Yd=disposable incomeThe income of the economy will increase by 100 if the government expenditure increases byA. 25

B. 40

C. 60

D. 100 (97-19)15. In an economy with taxes, C = 20 + 0.9Yd, where C is consumption and Yd is disposable income. The consumption function predicts that the consumption expenditure isA. 180 when the national income is 200.

B. 110 when the national income is 100.

C. 90 when the disposable income is 100.

D. 20 when the disposable income is 0. (97-24)16. Suppose the marginal propensity to consume is 0.75. Under a lump sum tax system, how much tax decrease would have the same effect on the equilibrium income as a $45 million increases in government spending?A. $25 million

B. $60 million

C. $120 million

D. $180 million (98-02)

17. A deflationary gap exists if _____ at the full employment level.(1) income is greater than expenditure.

(2) realized investment is smaller than planned investment.

(3) planned saving is greater than planned investment.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (98-03)

18. If the government adopts a proportional income tax, the aggregate expenditure curve will _____ and the investment multiplier will become _____.A. flatter ... smaller

B. steeper ... smaller

C. flatter ... larger

D. steeper ... larger (98-25)

19. In the elementary Keynesian model, fluctuations in investment will induce _____ fluctuations in income under the proportional tax system _____ under the lump sum tax system.A. more ... than

B. less ... than

C. the same amount of ... as

D. no ... or (99-05)


C=250 + 0.7Yd


I=200


T=100 + 0.2Y

T=tax

G=500


Yd=disposable incomeAt equilibrium, the government budget surplus is _____ and the government expenditure multiplier is _____.A. negative ... 3.33

B. negative ... 2.27

C. zero ... 2.27

D. positive ... 3.33 (00-06)21. Consider the following diagram of a closed economy:

Which of the following is true at the equilibrium income level?A. Investment is greater than saving.

B. Investment is equal to saving.

C. Investment is smaller than saving.

D. The answer is indeterminate. (01-01)

22. Which of the following will reduce the size of the government expenditure multiplier?(1) an increase in the proportional income tax rate.

(2) a decrease in the marginal propensity to invest.

(3) a decrease in the marginal propensity to save.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (01-02)

23. Consider the elementary Keynesian model with a lump sum tax but without foreign trade. Suppose the equilibrium income is $500 and the full employment income is $600. If full employment can be achieved by a $50 increase in government spending, then what decrease in lump sum tax is needed in order to achieve dull employment?A. $25

B. $50

C. $75

D. $100 (01-29)24. Consider the following model:

C=150 + 0.8Yd


I=70 + 0.15Y


T=30

T=lump sum tax

G=50


Yf=5 080

Yd=disposable income

Y=national income

Yf=full employment national incomeIn order to attain the level of full employment national income, what is the required change in the lump-sum tax?A. -8

B. -10

C. 8

D. 10 (02-04)25. If a government reduces its expenditure and increases the transfer payments by the same mount,(1) the equilibrium income will decrease.

(2) the total amount of money held by the public will increase.

(3) the level of investment will increase.

A. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3) (02-05)

26. Refer to the following closed economy:

C=200 + 0.8Yd


I=100


T=0.4Y

T=taxation

G=200



Y=national incomeThe expenditure multiplier is A. 1.67

B. 1.92

C. 2.08

D. 5 (03-02)27. Which of the following cases will exert an expansionary effect on the economy where there is an equal increase in government expenditure and tax?(2) There is proportional tax and no marginal propensity to invest.

(3) There is proportional tax and positive marginal propensity to invest.

(4) There is no proportional tax, but positive marginal propensity to invest.

(5) There is no proportional tax and no marginal propensity to invest.

A. (1) and (2) only

B. (1) and (4) only

C. (2) and (3) only

D. (1), (2), (3) and (4) (03-04)28. Define private saving as Sp = Y T C, public saving as Sg = T G and national saving as the sum of private and public savings. Y, T, C, and G are national income, tax, consumption expenditure, and government expenditure, respectively. It follows that, in an open economy,A. private saving is equal to domestic investment.

B. national saving is equal to domestic investment.

C. private saving is equal to the sum of domestic investment and net exports.

D. national saving is equal to the sum of domestic investment and net exports. (03-10)

29. Refer to the following diagram of a closed economy.

Which of the following statements about the economy is correct?A. At Y1, the level of foreign exchange reserves must constant.

B. At Y1, the budget surplus is zero.

C. At Y1, the value of injection (I + G) is equal to the value of withdrawal (S + T).

D. At Y1, there will be an increase in inventory. (04-06)

30. Refer to the following diagram of a closed economy.

Full employment and budget balance can be attained simultaneously whenA. there is an increase in autonomous investment.

B. there is an increase in autonomous government expenditure.

C. there is a reduction in both lump sum tax and government expenditure by the same amount.

D. there is a reduction in lump sum tax. (04-08)

31. In a closed economy with the government sector, consumption rises by $60 when disposable income rises by $100. Which of the following about the economy must be true?(1) The marginal propensity to save is 0.4.

(2) The average propensity to consume is 0.6.

(3) When investment increases by $20, the maximum possible increase in national income is $50.

A. (1) only

B. (1) and (2) only

C. (1) and (3) only

D. (2) and (3) only (05-04)

32. Which of the following will reduce the expansionary effect of an increase in government expenditure in the elementary Keynesian model?A. an increase in lump sum tax.

B. a decrease in the marginal propensity to save.

C. a decrease in the marginal propensity to import.

D. All of the above. (05-05)

33.

The above diagram shows an elementary Keynesian model for a closed economy. In this economy, all taxes are in lump sum fashion and investment is autonomous. The aggregate expenditure function shifts upward from E1 to E2 as a result of a change in lump sum tax. The change in lump sum tax is _____.A. 50

B. 62.5

C. - 50

D. - 62.5 (06-03)

34. In a closed economy, national saving is $1 000 and private saving is $750. This means that the government has a _____ and the equilibrium level of investment is _____.A. budget deficit of $250 ... $250

B. budget deficit of $1000 ... $1 000

C. budget surplus of $250 ... $1 000

D. budget surplus of $200 ... $250 (06-04)

35. In a closed economy where investment is autonomous, the marginal propensity to consume is 0.8 and the proportional income tax rate is 10%. The national income will increase by $50 billion ifA. there is an equal increase in government expenditure and lump sum tax by $50 billion.

B. lump sum tax is reduced by $12.5 billion.

C. autonomous saving is reduced by $14 billion.

D. there is an increase in investment expenditure of $20 billion. (06-06)

Study the following information about a closed economy and answer Question 36 and 37

C=0.8 Yd


I=200


T=0.5 Y


Yf=1 200


T=taxes

Y=national income

Yf=full employment income

36. If the governments objective is to achieve full employment by choosing its expenditure, the government will have a fiscal of _____ of _____ when it achieves the objective.A. surplus 80

B. deficit 80

C. surplus 100

D. deficit 100 (07-03)

37. If the governments objective is to achieve fiscal balance by choosing its expenditure, the equilibrium income level will be _____ when it achieves the objective.A. 1 000

B. 1 200

C. 1 600

D. 2 000 (07-04)

38. Which of the following can offset the effect of an increase in income tax rate on the expenditure multiplier?A. a reduction in lump sum tax

B. an increase in autonomous investment

C. a reduction in the marginal propensity to import

D. an increase in the marginal propensity to save (07-06)

MC Answers on Three-sector National Income Model

(ii) Three-sector National Income Model

1989 Q. 2

Explain why tax-financed government expenditure is expansionary. (10 marks)

By financing government expenditure with tax, it means that the amount of expenditure spent by the government is the same as the amount of tax revenue received from the public. In this case the government adopts a balance budget.

By adopting a balanced budget, although the amount of government expenditure is the same as the amount of tax revenue received from the public, the effect on income is expansionary. This is because the marginal propensity to consume of the government is equal to 1 while the marginal propensity to consume of the public is smaller than 1.

If tax is increased by $1, the disposable income of the public will fall. However, since the marginal propensity to consume is smaller than 1, the fall in consumption demand will be equal to cT*, i.e. smaller than $1. On the other hand, as the government will spend the whole $1, the increase in government expenditure will be equal to1. As a result, there will be a net increase in demand by (G* + -cT*). Hence, tax-financed government expenditure is expansionary.

1989 Q. 7

(a) A proportional tax system is often praised for its built-in stabilizing effect. However, it reduces the responsiveness of an economy to discretionary fiscal policies. Explain. (16 marks)With the adoption of a proportional tax system, the disposable income of households will fall. As the consumption is mainly a function of disposable income, consumption out of income will also fall. Moreover, it also leads to a smaller multiplier which is measured as

k = 1 / [ 1 c (1-t) ]As the value of multiplier under proportional tax system is smaller than one without proportional tax, it can serve as an automatic stabilizer which helps to reduce the fluctuations of income in times of economic changes. For example, if there is a fall in investment, there will be a fall in autonomous spending. Through the multiplier effect, income will fall by a multiple of the initial fall. With the proportional tax system, since the multiplier effect is being weakened, the resulting fall in income will become smaller.

On the other hand, if there is a sudden rise in autonomous spending, the income level will rise by a multiple of the initial rise because of the multiplier effect. With the proportional tax system, the resulting rise in income will also be smaller.

So, to conclude, with the existence of proportional tax system, income fluctuations within the economy will be smaller in times of ups and downs of the economy as it helps to stabilize the income of the economy.

However, since the value of multiplier becomes smaller with the existence of proportional tax system, it also reduces the responsiveness of an economy to discretionary fiscal policies. For example, if the government intends to raise the employment level, it can achieve this goal by increasing its spending. However, since the multiplier effect is being weakened by the proportional tax system, the resulting change in income will become smaller than without tax. As a result, in order to raise income to a certain level, the government has to rise its spending or reduce taxes (lump-sum) by a larger amount so as to compensate for the reduced responsiveness of the economy to discretionary policies.

(b) In the light of (a), comment on the following statement:

The desirability of employing a proportional tax system depends on the state of the economy. (9 marks)If the economy is closed to or at the full employment level, proportional income tax system is good because it can stabilize the economy around the full employment level. However, when the economy is far below the full employment level where government discretionary policy is required to achieve full employment, then the small multiplier value under the proportional tax system is not desirable.

1990 Q. 1

Explain what is meant by automatic stabilizers of fiscal policy. Give at least two examples. (10 marks)

Automatic stabilizers of fiscal policy are also called automatic tools of fiscal policy or built-in stabilizers.

By automatic stabilizers, we mean those institutional arrangements that automatically increase government deficit, or decrease surplus, during recessions. On the other hand, they also automatically increase surplus, or decrease deficit, during booms, without the government having to male any policy decision. Thus, with these automatic tools, it can help to reduce the fluctuations of income without the implementation of discretionary policies.

Examples of automatic stabilizers are progressive tax system, unemployment benefits and other income-support programs.

1992 Q. 2

Consider the elementary Keynesian closed economy with consumption, autonomous investment and government expenditure so that in equilibrium Y = C + I + G. Suppose consumers of this economy are of two groups, half of them having consumption functions C1 = 0.8Y1 and the other half having consumption functions C2 = 0.9Y2.

(a) Find the aggregate consumption function if each group earns half of the aggregate income. Show your steps. (4 marks)

C1= 0.8Y1=0.8(0.5Y)

C1= 0.9Y2=0.9(0.5Y)

C = C1 + C2 = 0.85Y

So, the aggregate consumption function is C = 0.85Y.

(b) Assume some income is transferred from those with a low MPC to those with a high MPC.

(i) What will be the effect on equilibrium aggregate income? Explain briefly. (4 marks)

If some income is transferred from those with a low MPC to those with a high MPC, the aggregate consumption function will be shifted upwards. With an increase in aggregate consumption, the equilibrium aggregate income will rise as a result.

(ii) Suppose investment is dependent on the interest rate. Briefly explain what kind of investment function will lead to results similar to that in (i). (4 marks)

The redistribution of income will lead to less saving, which will push up the interest rate. However, if the investment function is inelastic, an increased interest rate only slightly decreases investment. As a result, the resulting rise in aggregate demand and the equilibrium aggregate income will be similar to that in (i).

1993 Q. 7

If the new project costs HK$170 million over the next four years, and the government decides to finance this expenditure entirely by taxation without borrowing, will such a fiscal policy be expansionary, contractionary, or neutral? Explain. (10 marks)

If the spending on the airport project is exactly financed by increased taxation of the same amount, the fiscal policy effects is the same as adopting a balanced budget. Thus, the effect on the economy will be expansionary.

The reason is that since the MPC of the private sector is smaller than 1, if income is not taxed, the private sector will save part of it. If it is taxed, the government will spend all the tax revenue in this case. This means that the MPC of the government is equal to 1. Therefore the expansionary effect of increased government spending is greater than the contractionary effect of increased tax.

To illustrate this, we can take a case of lump-sum tax in a three-sector model with autonomous investment. The value of the multiplier is equal to one. If marginal propensity to consume is (c), the multiplier from increase spending is 1 / (1 - c), while the (negative) multiplier from increased taxation is c / (1 - c). Hence, the balanced-budget multiplier is equal to 1 / (1 - c) + [ -c / (1 - c)] = 1Or we can say that national income in creased by the same amount of government spending. So if other thing being equal, Hong Kongs national income will increase by 170 billion.

1994 Q. 1

Consider the following economic model:

C=20 + 0.8YdwhereC=consumption expenditure

T=0.25 (Y - 100)


I=100

T=tax

G=60

Y=income



(a) Find the income multiplier. (2 marks)

The income multiplier=1 / (s + t)

=1 / [0.2(1-0.25) + 0.25]

=2.5(b) Find the equilibrium values of income, consumption and the government budget surplus. (6 marks)

Since Y=C + I + G

=20 + 0.8(Y 0.25Y + 25) + 100 +60

=500

Hence, the value of income is equal to 500.

As C

=20 + 0.8Yd

=20 + 0.8[500 0.25(500) + 25]

=340

The equilibrium value of consumption is equal to 340.

The government budget surplus=T G

=0.25(500-100) 60

=40The government budget surplus is equal to 40.

1994 Q. 4

Use the elementary Keynesian model to compare the differences in the fluctuations in income caused by fluctuations in investment under lump-sum and proportional tax systems. (8 marks)

To make it simpler, lets take the fluctuations in investment as an increase in investment. As investment is taken as an autonomous spending, an increase in investment spending will lead to a rise in aggregate demand. With a positive MPC of the private sector, this will lead to a further increase in aggregate demand as well as output. Hence, the resulting rise in income will be a multiple of the initial rise in investment. The extent of fluctuations in income caused by fluctuations in investment is affected by the value of multiplier, i.e. the multiplier effect. In a three-sector model, the extent of fluctuations in income is mainly affected by the tax system adopted by the government.

Basically, there are tow types of tax system adopted by the government, lump-sum tax and proportional tax systems. If lump-sum tax is imposed, the amount of tax received is independent of the level of income. In this case, although a rise in investment causes income to rise, the amount of tax will remain unchanged. Hence, the value of multiplier under a lump-sum tax system will be equal to 1 / (1 - c).

On the other hand, if proportional tax system s adopted, the amount of tax received is a fixed percentage of the amount of income. With a rise in investment, income will rise and the amount of tax paid will also rise. In this case, the rise in disposable income of the private sector will be smaller than under a lump-sum tax system. Hence, the value of multiplier will be equal to 1 / [1 c (1 - t)].

By comparing the value of multiplier under the two tax system, we can see that the value of multiplier under lump-sum tax system. So we can conclude that with an increase in investment, the fluctuations in income will be greater under lump-sum tax system.

1995 Q. 1

Consider the elementary Keynesian model.

(a) Explain how an increase in the lump-sum tax affects income. (4 marks)

Under the elementary Keynesian model, income is determined by the level of consumption demand and investment demand.

While consumption demand is a function of disposable income, an increase in the lump-sum tax will decrease disposable income. With a fall in disposable income, consumption expenditure will fall by the amount cT*. As the level of income (output) will also fall. Through the multiplier effect, income of the economy will fall by a multiple of the lump-sum tax equal to [1 / (1 - c)] x cT*.

(b) Suppose the tax multiplier of the lump-sum tax is -4. By how much will income change if the government expenditure increases by 100? (4 marks)

As the tax multiplier measures how many times income will change with a lump-sum tax of $1, it can be derived by using the following formula:

Tax multiplier=Y / T*

=-c / (1 - c)If the tax multiplier is -4, this means that the value of MPC is equal to 0.8. With the MPC equals to 0.8, the value of the simple multiplier will be equal to

Simple multiplier=1 / (1 - c)

=1 / (1 0.8)

=5This implies that an increase in autonomous spending by $1 will lead to an increase in income by 5. With an increase in government expenditure by$100, the increase in autonomous spending will also rise by 100. As a result, the increase in income will be equal to 500.

Change in income=[1 / (1 - c)] x G*

=1 / (1 0.8) x 100

=5001995 Q. 2

(a)Explain, with the aid of a diagram, how an increases in both investment and the marginal propensity to save affect the employment level of income of an economy.

(4 marks)

As investment is a kind of injection of an economy, an increase in investment increases injection and the investment function will shift upward. On the other hand, as saving is a kind of leakage of an economy, if there is an increase in marginal propensity to save, the amount of leakage will increase and the slope of the saving function will become steeper.

Since an increase in investment will lead to a rise in income while an increase in marginal propensity to save will lead to a fall in income. If they both occur, the effect in the employment level and the income level, of an economy is uncertain. They can either increase or decrease or remain unchanged, depending on the extent of changes in investment as well as the marginal propensity to save.

(b) Based on the result in (a), comment on the validity of the Paradox of Thrift.

(4 marks)

According to the Paradox of Thrift, an increase in saving is bad for a society as a whole as this will eventually lead to a fall in income and employment. This is true only when investment is assumed to be constant.

However, the result in (a) is not the same as suggested by the Paradox of Thrift. It shows that if an increase in saving is accompanied by an increase in investment, then income or employment will not necessarily fall.

1995 Q. 7

In an elementary Keynesian model, there is a proportional income tax and government expenditure just equals its tax revenue.

(a) Explain the impact of an increase in investment on income, the government budget balance and the external trade balance. (6 marks)

With an increase in investment, autonomous spending will rise and so will the level of aggregate demand. Through the multiplier effect, the level of income will rise.

Under a proportional tax system, if there is a rise in income, the amount of tax revenue will rise. Since government expenditure remains unchanged, the government will experience a budget surplus.

As the level of import is a function of income, an increase in income will result in an increase in spending on import. As receipt from export remains unchanged, the external trade balance will become less favourable.

(b) Suppose now the government is required to balance its budget. Explain whether the impact of an increase in investment on income will be larger or smaller than that in (a). (4 marks)

If the government is required to balance its budget, this means that it has to increase the government expenditure or decrease the tax revenue.

If there is an increase in government expenditure, the level of demand will increase. Through the multiplier effect, income will increase by a multiple of the government expenditure.

If the tax revenue decreases, the level of consumption demand will increase as a result of an increase in disposable income. Through the multiplier effect, income will increase by a multiplier of the tax revenue.

Since both an increase in government expenditure and a decrease in tax revenue will raise income, if the government is required to balance its budget, the impact if an increase investment on income will be greater than that in (a).

1997 Q. 1

Consider an elementary Keynesian model with proportional income tax and unemployment. Suppose the government budget is in deficit. Show how a $1 increase in government expenditure affects

(a) national income. (4 marks)

If government expenditure increases by $1, aggregate demand will rise. Through the multiplier effect, national income will rise which is equal to $1 x [ 1 / (1-c)(1-t) ].

(b) government budget deficit. (4 marks)

As an increase in government expenditure by $1 raises the national income, tax revenue will also increase under a proportional income tax. The increase in tax revenue is equal to

t x [ 1 / (1-c)(1-t) ] which is smaller than $1, i.e., the increase in government expenditure. Hence, government budget deficit will be increased.

1996 Q. 4

Consider a country with unemployment. With the aid of a diagram, explain how an equal increase in government expenditure and lump-sum tax affects the income of the country. Show that the balanced budget multiplier is one. (8 marks)

With an increase in government, the C + I + G curve will be shifted upward by an amount of G*. On the other hand, if the lump sum tax increase by the same amount, the C + I + G curve will be shifted downward by cG*. Thus, there is a net upward shift of (1-c)G*. With the multiplier equal to [1 / (1-c)], income will increase by [1 / (1-c)] (1-c)G*which is equal to G*. Thus, income multiplier is equal to 1.1997 Q. 4

The following table gives the composition of Country As GNP:

ConsumptionInvestmentGovernment ExpenditureGNP

145X30200

(a)(i) Find the value of X. Is the value a realized investment or a planned investment?

(2 marks)

As GNP = C + I + G

I = 200 -145 -30

I = 25The value of X is a realized investment because the above figures show the actual amount of output as well as spending by various sectors.

(a)(ii) Explain whether the value you calculated in (a)(i) can be planned investment as well as realized investment. (2 marks)

At equilibrium, planned investment equals to realized investment. Thus, the value calculated in (a)(i) can be planned investment as well as realized investment if the value of GNP is at equilibrium level.(b) Suppose the planned investment is 30. Explain how country As GNP will change.

(4 marks)

If planned investment is 30, the equilibrium output will become 205. However, since the current GNP is only 200, there is excess demand in the economy. Hence, to restore equilibrium, Country As GNP will increase to 205.

1999 Q. 7

Consider an unfunded social security system in a closed economy with unemployment. The system involves a redistribution of income from young to old people, i.e., the young is taxed and the tax proceeds are distributed to the old as transfer payments.

There are 400 young people and 100 old people in the population. All the old people have retired and their pre-transfer income is zero. The consumption functions and disposable incomes of these two groups of people are given as follows:

C1= 10 + 0.75Yd1 whereC1=consumption of each young person

C2 = 20 + 0.9Yd2 C2=consumption of each old person

Yd1 = Y1 t Yd1=disposable income of each young person

Yd2 = tr Yd2=disposable income of each old person

Y1=pre-tax income of each young person

tr=transfer payment received by each old

person

(a) Give one reason why the marginal propensity to consume of the old may be higher than that of the young. (3 marks)

Firstly, as most of the olds children have already grown up and can support themselves, they have smaller need to care for the young. Thus they can spend a larger proportion of their income on consumption.

Secondly, the major purpose of saving up money is to prepare for the future. The longer the life expectation, the greater the saving will be. For the old, since they have a shorter life expectation, they have a smaller need to save. Hence, they will tend to spend more on consumption out of every additional of income than the young.

(b) Suppose the social security tax is the only tax in the economy and there is no government spending. Suppose further that these taxes and transfers are lump sums.

(i) Use the balanced budget condition to find tr given t = 100. (2 marks)

A balanced budget condition means that the resulting tax revenue collected from young people will be equal to the amount of transfers paid to old people. Thus,

Since t = 100, and tr* = t* x 400

So, tr = 400(ii) Based on your answer to (b)(i), find the aggregate consumption, C, (i.e., sum of consumption over both the young and old people) as a function of Y1. Then, divide this (pseudo) aggregate consumption function by the total population to obtain per capita consumption, c. Find c as a function of Y1. (3 marks)

Aggregate consumption (C) = C1 + C2

C1 = 400 x [10 + 0.75(Y1 - 100)]

C2 = 100 x [20 + 0.9(400)]

C = 12000 + 300 Y1

Per capita consumption (c) = C / (400 +100)

C = (12000 + 300Y1) / 500

C = 24 + 0.6Y1(iii) Suppose there is no such social security system in the economy. Find c as a function of Y1. (2 marks)

Without no such social security system,

Aggregate consumption (C) = C1 + C2

C1 = 400 x [10 + 0.75(Y1 - 0)]

C2 = 100 x [20 + 0.9(0)]

C = 6000 + 300 Y1

Per capita consumption (c) = C / (400 +100)

C = (6000 + 300Y1) / 500

C = 12 + 0.6Y1 (c) Use the elementary closed economy Keynesian model with no investment to explain the effect of the above social security system on the aggregate consumption, aggregate output, and aggregate saving of the economy. (4 marks)

As the marginal propensity to consume of the old is higher than the young, the social security system will lead to an increase in aggregate consumption. A dollar shift from the young to the old will lead to an increase in consumption spending by 0.15.

With the increase in consumption demand, the equilibrium aggregate output will increase to meet the increase in demand.

As for aggregate savings, since investment is assumed to be non-existent, then at equilibrium Y = C. This means that all income will be spent on consumption and there will be no savings. Thus aggregate saving will remain constant at zero even though both aggregate consumption as well as aggregate output increases as a result of the above social security system.

2000 Q. 1

Consider an elementary closed Keynesian model. The only tax in the model is a lump sum tax.

(i) Suppose both government expenditure and tax increase by the same amount. Explain the impact of such changes on the equilibrium level of income. (4 marks)

With an increase in government expenditure, there will be a multiple increase in income. The increase is equal to G* x [1 / (1-c)].

On the other hand, if there is an increase in lump sum tax, there will be a multiple reduction in income. With a fall in disposable income, consumption will fall. However, since the marginal propensity to consume, i.e. (c), is smaller than 1, the fall in initial consumption will be equal to cT*. Hence, the fall in income will be equal to

cT* x [1 / (1-c)].

Hence, if both government expenditure and tax increase by the same amount, the effect

on the equilibrium level of income will be equal to G* x [1 / (1-c)] + { cT* x [1 / (1-c)] }.

This means that there will be an increase in the equilibrium level of income which is equal to the amount of increase in government spending, with the balanced-budget multiplier equal to 1.

(ii) Suppose government expenditure increases by an amount smaller than the increase in tax. Explain the impact of such changes on the equilibrium level of income. Under what condition will the impact be zero? (4 marks)

If government expenditure increases by an amount smaller than the increase in tax, whether the equilibrium level of income will rise or fall depends on whether the effect on initial spending due to an increase in government expenditure (G*) is greater than that of an increase in tax (-cT*). If G* is greater than cT*, then the equilibrium level of income will rise. If G* is smaller than cT*, then the equilibrium level of income will fall. While if G* is equal to cT*, then the impact of such changes on the equilibrium level of income will be zero.

2001 Q. 6

C=100 + 0.75Yd WhereC=consumption expenditure

I=100 Yd=disposable income

G=200 I=investment

T=0.2 Y G=government expenditure

T=tax

Y=income

(a) Find the government expenditure multiplier, the equilibrium income and the government budget balance. (6 marks)

Ye = C + I +G

= 100 + 0.75(Y 0.2Y) + 100 + 200

0.4Y = 400

Ye = 1000Government expenditure multiplier (K) = 1 / [(1-c)(1 - t)]

= 1 / (1-0.75)(1 -0.2)

= 2.5Government budget balance = T G

= 0.2 x1000 - 200

= 0 (Balanced)

(b) Suppose investment decreases.

(i) Explain the impact on equilibrium income and the government budget balance.

(4 marks)

As Y = C + I G. if there is a fall in investment, there will be a fall in aggregate expenditure. Thus there will be excess supply at the original equilibrium income level. To restore equilibrium there will be a fall in output and income. Hence, equilibrium income will fall if investment decreases.

As government budget balance equals to T G where the amount of tax revenue is positively related to income, the amount of tax revenue will fall with a fall in income. Since the level of G is independent of income, the government budget balance will be worsened if investment decreases. In other words there will be a budget deficit.(ii) Suppose the government adjusts the tax rate to balance its budget. Explain whether the equilibrium income under this situation will be higher or lower than that in (i).

(3 marks)

Since the amount of tax revenue fall with a fall in income when investment decreases, a budget deficit will arise. If the government adjusts the tax rate to balance its budget, this implies that it has to raise the tax rate in order to increase its tax revenue at every level of income. With a rise in tax rate, disposable income of household will fall and the marginal propensity to consume out of income will also fall. As a result, there will be a further reduction in the equilibrium income. Hence, the equilibrium income under this situation will be lower than that in (i).

2003 Q. 7

The Hong Kong government is very much concerned with the problem of budget deficits. One measure the government has adopted is to cut its spending by reducing the salaries of the civil servants. In principle, the government could also raise the salary tax to achieve similar results. Another measure the government is contemplating is to increase its revenue by introducing a sales tax.

The following questions try to compare the revenue-raising effects and other economic effects between an income tax and a consumption tax using a simple Keynesian model. Suppose the consumption function takes the form C = 30 + 0.8Yd, where Yd = Y T, Y is national income and T is tax. In the case of an income tax, T = 0.25Y; whereas in the case of a consumption tax, T = 0.25C, where proportional tax rates on income and consumption are both 25%. For simplicity, suppose the economy is closed with no investment, but there is a positive level of government expenditure G = 120. In equilibrium, Y = C + G.

(a) In the case of an income tax, find the equilibrium level of income. How much revenue can the government raise? (3 marks)

Y = 375 and T = (0.25)(375) = 93.75; C = 30 +0.6(375) = 255

(b) In the case of consumption tax, find the equilibrium level of consumption. How much revenue can the government raise? [Hint: You should first show the consumption satisfies C = 25 + (2/3) Y.] (5 marks)

First, C = 0.8Yd with Yd = Y (0.25)C implies that C = 25 + (2/3)Y. Then, Y = 435, C = 315, and T = (0.25)(315) = 78.75.

Y = 435; C = 315; T = 0.25(315) = 78.75(c) Based on your answer to (a) and (b), compare revenue-raising as well as other effects on the economy of the two kinds of taxes. (4 marks)

Hence, the income tax can generate more tax revenue than the consumption tax at the expense, however, of lower levels of (pre-and post-tax) income and consumption. (Note that the levels of national saving are the same in both cases; but private saving will be lower the income tax than under consumption tax.)(d) If you have answered (c) correctly, you will have found that (at the same tax rate) the consumption tax cannot generate as much tax revenue as the income tax. Can you describe some advantages of taxing consumption in practice? (2 marks)

In the absence of exemption allowances, more people will fall into the tax net under the consumption tax than under the income tax, so that the former may end up g

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1990-2007 AL-Econ-Macro-Past Paper (Sorted by Topics)