Sept 2020, Question 33

[Eleanor Cawston]

A couple of things on this past paper question.
Firstly, this question is on "planned consumption" and "planned investment": are these actually explicitly covered anywhere? According to the ASET, the material is from Module 16, but I don't recall / find these terms actually mentioned. Am I blind, or is this something I should somehow derive for myself from the material?

Secondly, I don't understand the answer to part (ii) - it seems kind of circular?
We work out in part (i) that savings are equal to 60, by equating to investments at the equilibrium level. But this doesn't help to identify where the equilibrium level is, since investments are 60 at all levels of income.

In part (ii), the solution says that the the economy is in equilibrium at an income of 200 as then I = S. But by this reasoning, the economy is in equilibrium at all levels of income!
The next 2 sentences in the solution seem to say that the economy is in equilibrium if there are no unplanned additions to stocks and as there are no unplanned additions to stocks it is in equilibrium. But since we have seen that S = I everywhere, and according to the table there are unplanned additions to stocks at all levels of income except 200, then this reasoning seems either circular or incomplete.

The table shows clearly that there is no unplanned addition to stocks at income = 200, but this is not part of the actual solution.

Thanks for any help,
Eleanor

 

[Richie Holway]

Hi Eleanor,

I think the examiners have used the words planned consumption and planned investment as the figures provided are not actual figures. In other words, how much consumers and firms spend will depend on national income. Looking forward, they might be able to say how much they will spend assuming different income levels, but as they don’t know exactly what their income will be, they can’t say exactly what they will spend.

Although investments are 60 at all levels of national income, savings are only equal to £60m at an income of £200m, and so this is the only level of income for which savings equal investment and hence the only equilibrium position. For example, at an income of £250m, savings are equal to 250 – 175 = £75m, but this does not equal the £60m planned investment at that income level, and so an income of £250m is not an equilibrium position. The same argument can be made for all other income levels.

There are no unplanned additions to stocks when in equilibrium because in equilibrium, aggregate demand (AD) equals national income (Y). Recall that AD (or aggregate expenditure) is how much money is spent in the economy and Y is what is earned or produced (national income and national output are the same thing). So in equilibrium, since AD (what is spent) equals Y (what is produced), exactly everything that is produced is purchased, and so there is no change in the level of inventories (stocks).

Note that AD is normally C + I + G + X – M, but since we are told that this is a closed economy with no government spending, G, X and M are all 0 and so AD = C + I.

Richie

 

[Eleanor Cawston]

Hi Richie,
OK, I think I get it now.

For part (i), we use that Y = E for equilibrium and E = Cd + J = Cd + I + G + X
But G = X = 0
So Y = Cd + I which is only true at income of 200 and so this is the equilibrium level of income.
Since J = W for equilibrium, and in this case J = I and W = S, S = 60

I was confused by the ASET solution here where it mentions "at all levels of income" - this fact is irrelevant.

Thanks for your help.
Eleanor