ECS1601/203/1/2016

Tutorial Letter 203/1/2016

Economics 1B

ECS1601
Semester 1
Department of Economics

IMPORTANT INFORMATION:
This tutorial letter contains a discussion of the
questions in Assignment 03.

CONTENTS

DISCUSSION OF ASSIGNMENT 03/2016 .......................................................................................... 3

ECS1601/203
Dear Student

This tutorial letter contains the answers to the multiple-choice questions in Assignments 03, with brief
explanations where necessary. In most cases, however, we merely refer you to the prescribed textbook
and/or the study guide. If you have any questions about the answers that are provided, please discuss
them with your fellow students and your e-tutor on the e-tutor website.
1

DISCUSSION OF ASSIGNMENT 03/2016

All references, unless otherwise indicated, are to the prescribed textbook: Mohr, P & Associates. 2015.
Economics for South African students. 5th edition. Pretoria: Van Schaik.
3.1

Only statement [4] is correct.

In section 17.1, it is explained that spending may be equal to production and income, in which case
there will be no tendency for change. Spending may also exceed production and income, in which
case production and income will tend to increase. Sometimes spending may be less than production,
in which case production and income will tend to decrease. Therefore, statements [1], [3] and [5] all
represent possible situations that may exist. In section 17.1 it is also explained that some economists
believe that total spending will always equal total output and that the economy will always be in
equilibrium at the level of full employment. This idea was based on Says law, which states that
supply creates its own demand. Therefore, statement [2] is correct. Keynes, however, does not agree
with this, because he believes that aggregate demand (and not supply) is the force which determines
total production or income. That is why statement [4] is incorrect and the only correct alternative.

3.2

Only statement [3] is correct.

In box 17-2 on page 317 of the prescribed textbook, the assumptions of such a model and the
implications of these assumptions are discussed. As the economy is closed, there is no foreign sector
and as such exchange rates cannot be determined by any variable in the model.

3.3

Only statement [1] is correct.

On page 319 of the prescribed textbook it states that the value of induced consumption depends on
two things, namely the marginal propensity to consume and the level of income. The other options
refer to determinants of autonomous consumption as discussed in box 17-3 on pages 319 and 320 in
the prescribed textbook.

3.4

Only statement [4] is correct.

The income of this household decreases by R3 000 and its consumption also decreases by R3 000.
The marginal propensity to save is zero, because a change in income has not contributed to a
change in savings. This means that the marginal propensity to consume of this household is equal to
one all additional income is consumed and none is saved.

3.5

Only statement [4] is correct.

Rate of return on investment (ROI) is given by expressing the net benefit from the investment as a
percentage of the cost of the investment. To determine the total cost of the investment, we have to
add the interest that has to be paid for the year to the initial amount paid. The interest is 10% of
R1 500 = R150, and thus the total cost of investment is R1 650. The net benefit is derived by
subtracting the increase in sales from the cost of the investment (R1 850 R1 650 = R200). The ROI
= R200 / R1 650*100 = 12,12%.
3

3.6

Only statement [5] is correct.

A2 equals autonomous spending. It is autonomous consumption plus autonomous investment. See
section 17.5 and figure 17-5 (a) on pages 324 and 325 of the prescribed textbook.

3.7

Only statement [2] is correct.

The gap represents investment spending, which is also autonomous by nature in a simple Keynesian
model. See figure 17-5 (c) on page 325 of the prescribed textbook.

3.8

Only statement [2] is incorrect.

The equilibrium level of income (Ye) can be calculated by multiplying the multiplier () with the level of
autonomous spending (). Autonomous spending () in this model is equal to + . The formula to
calculate the multiplier () in this simple model is 1/(1 ).

For alternative [1]:

1
1
1
=
=
=
= 5.
1
10,8
0,2
= + = 30 + 25 = 55
Y =
Y = 5 X R55 billion = R275 billion
Thus, alternative [1] is correct.
For alternative [2]:
1
1
=
=
=
1

10,75

1
0,25

= 4.

= + = 65 + 31 = 96
Y =
Y = 4 X R96 billion = R640 billion
Thus, alternative [2] is incorrect.
For alternative [3]:
1
1
1
=
=
=
= 10
1
10,9
0,1
= + = 45 + 5 = 50
Y =
Y = 10 X R50 billion = R500 billion
Thus, alternative [3] is correct.
For alternative [4]:
1
1
1
=
=
=
= 2,5
1
10,6
0,4
= + = 10 + 20 = 30
Y =
Y = 2,5 X R30 billion = R75 billion
Thus, alternative [4] is correct.

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For alternative [5]:
1
1
1
=
=
=
= 2,22
1
10,55
0,45
= + = 20 + 30 = 55
Y =
Y = 2,22 X R50 billion = R111 billion
Thus, alternative [5] is correct.
3.9

Only statement [3] is incorrect.

With a marginal propensity to consume (c) of 0,75, the multiplier is equal to

1
1

1
10,75

1
0,25

= 4. An

increase of autonomous spending of R10 million will lead to an increase of 4 10 =

40 . Statements [1] and [2] are correct when considering the equation to determine the
multiplier, for example: If c = 0,60, it means that = 1/1-0,60 = 2,5, but if c were greater at 0,80, then
= 1/1-0,80 = 5. This then also illustrates that the size of marginal propensity to consume determines
the size of the multiplier. Statement [4] is correct because with a marginal propensity to consume (c)
1
1
1
of 0,60, the multiplier is equal to
=
=
= 2,5. An increase of investment spending of
1

10,60

0,40

R100 million will lead to an increase of 2,5 100 = 250 . Statement [5] is correct
because the equation clearly states Y = x .

3.10 Only statement [5] is correct.

On page 324 of the prescribed textbook, it is stated that this line shows all possible equilibrium points
where total spending (A) equals total income (Y).
3.11 Only statement [2] is correct.
The correct answer is R35 million, because autonomous expenditure is equal to autonomous
consumption (R15 million) + investment (which is also autonomous, R20 million).
3.12 Only statement [4] is correct.
The part of an increase in income that is not spend on consumption is saved, therefore the marginal
propensity to consume plus the marginal propensity to save equals 1. This means that if the marginal
propensity to consume is 0,6, then the marginal propensity to save will be 0,4, because 0,6 + 0,4 = 1.
3.13 Only statement [5] is correct.
1

[ = 1/1 ]. Substitute the information into the equation: = [10,6 ] =

value of the multiplier is 2,5.

1
0,4

= 2,5, meaning that the

3.14 Only statement [5] is correct.

Y0 = , meaning:

The equilibrium level of income Y0 = 2.5 X R35 million, Y0 = R87,5 million.

3.15 Only statement [4] is correct.

If the marginal propensity to save increases by 0,1, it means that the marginal propensity to consume
decreases by 0,1, thus from 0,6 to 0,5. The formula for the multiplier is:
1
=
.
[1]

Substitute this information into the equation:

1
=
meaning that the value of the multiplier is 2.
[10.5]

To determine the equilibrium income level, Y0:

Y0 = (), meaning that the equilibrium level of income Y0 = 2(R35 million) = R70 million.

3.16 Only statement [5] is correct.

The size of the multiplier is influenced by the marginal propensity to consume, the tax rate and the
marginal propensity to import, but not by the level of autonomous expenditure. Government spending
is part of autonomous expenditure and therefore does not influence the size of the multiplier.
3.17 Only statement [3] is correct.
Government spending is autonomous and determined by fiscal policy. Although the level of
government spending will influence the level of income and it may be used to increase income
(expansionary policy) or decrease income (contractionary policy), this is never the sole purpose or
even main determinant of the level of government spending. The level of government expenditure will
mostly be determined by the needs of the economy, for example the need for public goods and the
need for income distribution (see sections 15.3 and 15.4). Statement [2] is incorrect because the only
possible systematic relationship between government spending and investment spending is a
negative one when government spending increases, and a large part of this spending is financed
with borrowed funds, this may result in an increase in the interest rate level in the economy, which will
decrease investment. This phenomenon is called crowding out and it is referred to in section 15.11.
Statement [4] is incorrect because all the variables that influence the level of autonomous expenditure
( , , , and ) and the variables that influence the size of the multiplier (c, t and m) determine the
income level, not only the level of investment. Statement [5] is incorrect because, unlike expenditure
by households and business, which is determined by their income level, government spending is
determined by the needs of the economy, and only once the level of government spending has been
determined, the ways to raise the necessary tax revenue to finance this tax revenue are determined.
3.18 Only statement [2] is correct.
The tax rate influences the level of disposable income, and therefore the level of induced
consumption. A higher tax rate will decrease the level of induced consumption and vice versa.
Statement [1] is incorrect. Tax revenue is not equal to government spending because governments
also borrow funds to finance government expenditure. Also, it does appear in the aggregate
expenditure function because the aggregate expenditure function includes consumption and the
function for consumption is = + ( ). Statement [3] is not correct because tax increases or
decreases induce consumption and have no effect on autonomous spending. Statement [4] is not
correct because government spending does not increase invariably as tax revenue increases. As
explained in the discussion for question 3.17 above, government spending is autonomous and not
determined by total tax revenue. Also, tax decreases aggregate expenditure because they decrease
consumption expenditure. Statement [5] is not correct because tax revenue is not fixed, but
determined by the level of income. The tax rate is determined by the Minister of Finance and the
treasury, and may also vary from year to year.

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3.19 Only statement [4] is incorrect.
The tax rate influences the marginal propensity to consume negatively. The equilibrium level of
income will decrease due to the decrease in induced consumption, and therefore the expenditure line
will be flatter. Statement [1] is correct. Taxation influences induced consumption and not autonomous
consumption or spending. Statement [2] is correct because taxation will decrease the marginal
propensity to consume, and thereby decrease induced consumption and decrease the multiplier
effect. Statement [3] is correct. Owing to the decrease in induced consumption when taxes are
introduced, there will be a decrease in equilibrium income. Statement [5] is correct since taxation is
an instrument of fiscal policy. By changing the tax rate the value of the multiplier changes and as the
multiplier change the equilibrium level of income changes.
3.20 Only statement [4] is correct.
First you need to calculate the equilibrium level of income by using the following formula:
0 = + (1 ) + + .
Substitute the information into the equation:
0 = 100 + 0,8(1 0,25)0 + 460 + 400
0 = 100 + 0,8(0,75)0 + 460 + 400
0 = 100 + 0,60 + 460 + 400
0 = 960 + 0,60
0 0,60 = 960
0 0,60 = 960
0,40 = 960
960
0 =
= 2 400 .
0,4

Thus, the equilibrium level of income is R2 400 billion.

To calculate the equilibrium level of consumption, the following equation is used:

= + (1 )0 .

Substitute with available information:

= 100 + 0,8(1 0,25)(2 400)
= 100 + 0,8(0,75)(2 400)
= 100 + 0,6 (2 400)
= 100 + 1 440
= 1 540 .

Thus, the equilibrium level of consumption is R1 540 billion.

3.21 Only statement [4] is correct.

Use the following equation:
0 = + (1 ) + +

Substitute with the available information:

0 = 100 + 0,8(1 0,25) + 200 + 300
0 = 100 + 0,8(0,75)0 + 200 + 300
Y0 = 100 + 0,6Y0 + 200 + 300 million
0 = 600 + 0,60
0 0,60 = 600
0 0,60 = 600
0,40 = 600
600
0 =
0,4

0 = 1 500 .

The equilibrium level of income is thus R1 500 million.

3.22 Only statement [4] is not correct.

An increase in government spending increases aggregate spending and also increases the
equilibrium level of income. Similarly, a decrease in government spending decreases aggregate
spending and therefore the equilibrium level of income. An increase in taxes results in a decrease in
consumption, and therefore a decrease in aggregate spending and the equilibrium income level.
Similarly, a decrease in taxes will result in an increase in induced consumption, and therefore an
increase in aggregate spending and the equilibrium income level. Refer to section 18.1 of the
prescribed textbook, where fiscal policy is discussed.
3.23 Only statement [1] is correct.
Exports are autonomous and are not influenced by the level of domestic income. They are influenced
by economic conditions in the rest of the world, our international competitiveness and the exchange
rate. Refer to section 18.2 of the prescribed textbook, where exports (X) are discussed.
3.24 Only option [1] is correct.
Autonomous spending is not affected by a change in the tax rate. Taxes influence the level of induced
expenditure in the Keynesian model. The tax rate determines the level of disposable income, which
determines the level of induced consumption and thus the level of consumption spending by
households. Consumption is one of the components of aggregate spending and therefore its level
affects the level of aggregate income. Therefore, options [2], [3] and [5] are not correct. Because the
tax rate affects the level of disposable income available for consumption, it determines by how much
consumption will increase when the income level changes, and therefore it does influence the size of
the multiplier. Therefore, option [4] is also not correct.
3.25 Only statement [5] is not correct and thus the correct option.
Imports have an autonomous and induced component. Even though autonomous imports are not
influenced by the level of income, the induced part of imports is influenced by the income level.
Therefore, imports will increase and decrease as the level of income in the economy increases and
decreases. For this reason, option [1] is correct. Any variable that influences the level of income will
therefore also influence the level of imports, and therefore options [2], [3] and [4] are correct. When
government spending and investment increases, the level of income will increase and therefore
imports will also increase. When the tax rate decreases, the level of income will increase and
therefore imports will also increase.

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3.26 Only option [1] is correct.
Y0 shows where the A function intersects the 45 line. The A function includes only consumption
spending (C), investment spending (I) and government spending (G), and is therefore representative
of a closed economy with no foreign sector.
Option [2] is not correct. The full employment level of income is usually indicated with Yf it does not
appear in this diagram.
The income level where exports and imports are equal is where the line showing domestic spending
(A = C + I + G) and the line showing aggregate spending (A1 = C + I + G + (X Z)) intersect.
Therefore, option [5] is not correct. If the slopes and positions of the curves were such that they
intersected on the 45 line, the equilibrium level of income would be where exports and imports are
equal. This is not the case here and therefore option [3] is not correct.
Given that this is an open economy (i.e. A1 is the relevant spending function), aggregate expenditure
at an income level of Y0 will be below the 45 line, and thus the level of income will exceed the
aggregate expenditure. If, however, this is a closed economy (i.e. A is the relevant spending
function), the aggregate expenditure at an income level of Y0 will be on the 45 line, and thus the level
of income will be equal to aggregate expenditure. Thus, for neither of the two functions the level of
income is less than aggregate expenditure at Y0.
3.27 Only statement [1] is correct.
The autonomous part of exports and imports increases aggregate spending from A to A1. But the
expenditure line A1 is flatter than expenditure line A. This is because the multiplier has decreased
due to the increase of the marginal propensity to import, meaning that imports exceed exports. This
leakage out of the circular flow of income and spending will then decrease the total income from Y0 to
Y1. As indicated in figure 18-9, the balance of payments equilibrium is at the point where the curve
depicting domestic spending (A = C + I + G) intersects the total spending curve (A1 = C + I + G + (X
Z)). At any point to the left of this income level, total spending will exceed domestic spending, and
thus exports will exceed imports. At any point to the right of this income level, domestic spending will
exceed total spending, and thus imports will exceed exports. Therefore, option [1] is correct and
option [3] is incorrect. Y1 lies to the left of the intersection position and therefore domestic demand
(indicated on the A function) exceeds output here. Imports therefore exceed exports and option [2] is
incorrect. At Y1 the aggregate spending line (A1) crosses the 45 line, and the aggregate expenditure
is thus equal to output. Therefore, options [4] and [5] are both incorrect.
3.28 Only statement [4] is correct.
When income is zero, total spending is equal to autonomous expenditure, thus:
= + + ( )
= 5 + 10 + 15 + (12 17 )
= 5 + 10 + 15 5
= 25 .

Option [5] is incorrect. The slope of the consumption function and therefore the total spending
6
3
6
7
6
curve = (1 ) = 7 1 10 = 7 10 = 10.

3.29 Only statement [3] is correct.

The multiplier is calculated as follows:
= 1/[1 (1 ) + ].

If we substitute the values:

6
3
= 1/[1 1 + 0]
= 1/[1
= 1/[1
4
10

7
10
6 7
+ 0]
7 10
6
]
10

= 1/[ ] = 2,5.

3.30 Only statement [3] is correct.

The simplest way to calculate the equilibrium income level is to multiply the multiplier () (calculated
(calculated as
as 2,5 in the discussion of question 3.29) with the level of autonomous expenditure ()
R25 million in the discussion of question 3.28):

0 = = 2,5 25 = 62,5 .
We wish you all the best with your studies!
Your lecturers

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