Question

Assume a closed economy without Government. However, there exists a financial sector that creates an array of financial assets on which both households and firms invest. Let ? denote the average earnings from these financial assets. The consumption expenditure of the households is influenced by their wage income and the financial income and is given by ? = ?(?, ?); ?? > 0, ?? > 0, where ??, ?? are partial derivatives of consumption with respect to income ? and financial earnings ? respectively. Similarly, the real investment expenditure of firms is given by ? = ?(?, ?); ?? > 0, ?? < 0, where ??, ?? are the partial derivatives of the real investment with respect to income and financial earnings. Note that ?? < 0 implies that the real investment falls as financial earnings for the firm rises. Either using the Keynesian cross model or the Multiplier analysis, answer the following questions.

(i) Identify the “wealth effect” in this model? [2]

(ii) Derive the relationship between output ? and financial earnings ?, and examine the analytical conditions under which the relationship is positive ( ?? ??>0) and negative ( ?? ?? < 0). [15]

(iv) Describe why the scenario where the expansion in output driven by rise in financial earnings, i.e. when ?? ??>0, could make the economy unstable and vulnerable to crisis? [8]

Answer 1

In a closed economy without Government two models are given as - for Consumption expenditure Ic-c(y,x) where y wage Income ser financial bearnings. for real Investment Expenditure 1-1(Y,x) where, Yo Income x- Financial Earnings. It has also given that cy in the partial derivative of c with respect to y. i.e. cy=&c. & {cly, x)} = clen to ca is the partial derivative of t with respect tox (x-30 = 3{c(y, w)} = ('(441) Somelarly Iy, and Ix represents the partial derivatives of I with respect to y and a. i.e. Iy - 3 1 2 {2 (4, x)} = I'(x,x) ). IxPL Pr{1 (»)} - I'lY,«) <0. Answers The wealth effect can be derived from the second model or I westment expenditure moded. Because wealth is created ah through investment. That is investment. That is change investment over time can be called as wealth creation on .

capital formation. But in the model we can show it as the change in invertint due to change in income. Heke change means increase. Symbolically- 07 - 29 {I (7,4)} = I'(Y). relationship between Investment (I, and Incomedis positive, hence wealth effect is positive! Answer: The relation ship between output y and financial earnings can be denive in the following way. from the consumptio. to be the . x) * MYR - Creu change in consumption due to xx Change in consumption due to Y. since culoard cyto, hence dy yo. If we derive the relationship between 7 and & from the consumption function of then the relationship is positive.

If we denive the relation between y and ac from the Investment function then we get en I'l7, 2) e theme I'ly ) I'LY") как <e 1ус ла х 40. That is dy is a negative because & with respect to a is negative. 1 (iv) Answer: In in case of case of Investment we have Investment w. seen that, there is negative impact on inest ment due to increase in financial earnings. That is Ixo .<o. It indicates that increase financial earnings increase the daily consumption expenditure, but the daily expenditure reduces the saving capacity, which in turn reduces the investment. Thus, we get a negative we althouget a nositive relation between t and a from consumption ride, it could make the economy unstube and vulnerable to cinis An economy may be strong and stable only when there is more saving and investment. In other words the increase

future consumption may lead to an economy stron. But or increase in present cons- umption may lead to weak economy in future.