3 Classical Theory: Long Run

Question 1

Define disposable income

+ equation and assumptions

Answer 1

Disposable income is the income after that households can use to consume goods and services.

Disposable income = Y - T

We consider tax as a lump-sum tax.

Question 2

What is the equation for consumption?

Answer 2

Consumption is given by a consumption function: C = C(Y-T)

Question 3

Define marginal propensity to consume

Answer 3

Marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increases by one dollar. It is between 0 and 1.

Question 4

How can we represent the marginal propensity to consume diagrammatically?

Answer 4

Question 5

What does an MPC of 0.7 mean?

Answer 5

For every dollar of disposable income earnt, 70 cents are used for consumption and 30 cents are saved.

Question 6

Who purchases investment goods?

Answer 6

Both households and firms.

Households: buy new houses.

Firms: buy to add to their capital stock or replace depreciated ones.

Question 7

What does the quantity of investment goods demanded depend on?

Answer 7

Depends on the interest rate - the cost of the funds used to finance investment.

Question 8

What condition needs to be met for investment to take place?

Answer 8

Return (the revenue from increased future production) must be greater than its cost (the payments for borrowed funds).

As the rate rises, fewer investments are profitable so demand falls.

Question 9

Define nominal interest rate

Answer 9

The interest rate usually reported: the rate of interest that investors pay to borrow money.

Question 10

Define real interest rate

Answer 10

The nominal interest rate corrected for inflation.

Question 11

How can we show interest rates and investment on a diagram?

Answer 11

Question 12

What is the equation for a balanced government budget?

Question 13

When is there a budget deficit or budget surplus?

Question 14

In our model of national income how can we denote government and tax variables?

Answer 14

Question 15

What 5 equations can we use to determine supply and demand for the economy’s output?

Answer 15

Question 16

Steps to finding an economy’s equilibrium. Implications?

Answer 16

Question 17

How do we derive the equation for national saving?

Answer 17

Given Y = C + I + G then, Y - C - G = I which means that the remainder between output and (consumption + government spending), national saving, is equal to investment.

Question 18

What is private saving?

Answer 18

Question 19

What is public saving?

Answer 19

Question 20

How does public saving and private saving constitute national saving?

Answer 20

They sum. S = (Y - T - C) + (T - G) = I

Question 21

Show that national saving equals investment.

Answer 21

Question 22

Diagram for loanable funds market

Answer 22

Question 23

Loanable funds market as analogous to supply and demand

Answer 23

The “good” is loanable funds.

Saving is the supply of loanable funds - households lend their savings to investors or keep money in the bank that loans funds out.

Investment is the demand for loanable funds - investors borrow from the public directly through bonds or from the banking intermediaries.

Question 24

How does the interest rate self-adjust?

Answer 24

It adjusts until the amount of firms that want to invest equals the amount of households that want to save.

If the rate is too low, investors’ demand outweigh households’ supply (the cost of investing is cheaper, while the return on saving is low). Quantity demanded > quantity supplied, therefore price increases (rate increases).

Same other way around.

Question 25

How does an increase in government purchases addest the real interest rate?

[+ diagram]

Answer 25

Question 26

How does a decrease in taxes affect the real interest rate?

Answer 26

Reduction in taxes of ΔT causes disposable income to increase by ΔT. Consumption rises by ΔT × MPC.

Question 27

How does an increase in output affect the real interest rate?

Answer 27

Question 28

Why might investment demand increase?

Answer 28

Technological innovation

Before there are returns on new inventions or innovative ideas, they must first be invested into. Hence, an increase in technological innovation can correspond with an increase in investment demand.

Tax laws

For example, increase in personal income tax to subsidise tax cuts for investors into new capital. This encourages investment which increases demand.

Question 29

Diagram for an increase in investment demand (savings kept constant)

Answer 29

Question 30

Diagram for an increase in investment demand (savings as a function of interest rate)

Answer 30