The relationship between domestic demand and income $($output$)$: Explain why the

domestic demand for goods is considered an increasing function of income $($output$).$ Use

a graphical representation to illustrate this relationship. $(6$ Marks$)$

$$ How the demand for domestic goods is affected by imports and exports. $(6$ Marks$)$

$$ Explain why the trade balance is a decreasing function of output. Use a graph to support

your explanation. $(6$ Marks$)$

$$ How the equilibrium condition for output is determined. $(6$ Marks$)$

$$ The potential impacts of increased government spending on the domestic economy and

trade balance. $(6$ Marks$)$

$($a$),$ The domestic demand for goods is an increasing function of income $($output$).$

$($b$)$ and $($c$),$ The demand for domestic goods is obtained by subtracting the value of imports from

domestic demand and then adding exports.

$($d$),$ The trade balance is a decreasing function of output.

$$ The line AA represents the domestic demand for domestic goods, and the line DD

represents domestic demand.

$$ AA is flatter than DD$.$

$$ As long as some of the additional demand falls on domestic goods, AA has positive slope.

The line ZZ represents the demand for domestic goods $($including exports$).$

$$ The distance between ZZ and AA is constant because exports do not depend on domestic

income but they depend on foreign income.

$$ Because Y $=$ Z$,$ the equilibrium condition for output can be expressed as:

$$ Graphically, equilibrium output is at the point where demand equals output, the

intersection of ZZ and the $45-$degree line.

$3$

$$ The goods market is in equilibrium when domestic output is equal to the demand for

domestic goods. At the equilibrium level of output, the trade balance may show a deficit

or a surplus. Summary:

$$ An increase in domestic demand leads to an increase in domestic output but leads

also to a deterioration of the trade balance.

$$ An increase in foreign demand leads to an increase in domestic output and an

improvement in the trade balance.

$$ Implications:

$$ Shocks to demand in one country affect all other countries.

$$ Economic interactions complicate the task of policy makers. Policy coordination

is not so easy to achieve.