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Macro > CHAPTER 10 Basic Macroeconomic Relationships* > Flashcards

CHAPTER 10 Basic Macroeconomic Relationships* Flashcards

1
Q

What is the relationship between income and consumption?

A

Income and consumption are directly (positively) related, meaning as income increases, consumption generally increases.

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2
Q

How is personal saving defined?

A

Personal saving is “not spending” or the portion of disposable income (DI) not consumed. It is calculated as:

𝑆 =𝐷𝐼 − 𝐶

where S is spending, DI is Disposable income and C is Consumption

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3
Q

What is the significance of the 45° line in the income-consumption graph?

A

The 45° line represents points where consumption equals disposable income (C=DI). The vertical distance between the 45° line and the consumption line (C) represents saving.

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4
Q

What unusual trend occurred during the COVID-19 pandemic regarding consumption and income?

A

Between 2019 and 2020, disposable income increased due to government stimulus, but consumption fell as people saved more due to uncertainty.

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5
Q

What is the consumption schedule?

A

The consumption schedule shows planned consumption at different levels of disposable income. It typically indicates that households consume more as DI increases but a smaller proportion of large incomes.

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6
Q

How do the saving and consumption schedules relate?

A

The saving schedule is derived by subtracting consumption from disposable income. As DI increases, saving increases, while dissaving occurs when consumption exceeds DI.

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7
Q

What is the break-even income?

A

Break-even income is the level of DI where households consume their entire income (C=DI), resulting in zero saving.

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8
Q

What is the average propensity to consume (APC)?

A

APC is the fraction of total income spent on consumption:

APC= (Consumption)/(Income)

​

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9
Q

What is the average propensity to save (APS)?

A

APS is the fraction of total income saved:
𝐴𝑃𝑆 = Saving / Income

Key relationship:
APC+APS=1

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10
Q

What is the marginal propensity to consume (MPC)?

A

MPC is the fraction of any change in income consumed:

MPC= ΔConsumption​/ΔIncome

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11
Q

What is the marginal propensity to save (MPS)?

A

MPS is the fraction of any change in income saved:

MPS= ΔSaving/ΔIncome

Key relationship:
MPC+MPS=1

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12
Q

How are MPC and MPS related to the consumption and saving schedules?

A

The slope of the consumption schedule represents MPC, while the slope of the saving schedule represents MPS.

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13
Q

What happens to APC and APS as disposable income increases?

A

APC decreases, while APS increases, as a smaller proportion of income is consumed and a larger proportion is saved.

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14
Q

What is dissaving?

A

Dissaving occurs when households consume more than their disposable income, using savings or borrowing to finance the excess.

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15
Q

How did savings change during the COVID-19 pandemic?

A

The personal savings rate increased significantly, reaching 33.8% in spring 2020 due to increased uncertainty and stimulus payments.

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16
Q

What does MPC+MPS = 1 signify?

A

It shows that all changes in disposable income are either consumed (MPC) or saved (MPS).

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17
Q

What are the nonincome determinants of consumption and saving?

A

Wealth, borrowing, expectations, and real interest rates.

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18
Q

How does an increase in household wealth affect consumption and saving?

A

It increases consumption (shifts consumption schedule upward) and decreases saving (shifts saving schedule downward).

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19
Q

What is the wealth effect?

A

The tendency for households to consume more and save less when their wealth increases unexpectedly

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20
Q

How does borrowing impact current and future consumption?

A

Borrowing increases current consumption but reduces future consumption due to debt repayment, which lowers wealth.

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21
Q

How do expectations about future prices and income affect current consumption and saving?

A

Higher Future Prices: Increase current consumption and decrease saving.

Recession Expectations: Decrease current consumption and increase saving.

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22
Q

What is the effect of lower real interest rates on consumption and saving?

A

Lower real interest rates encourage borrowing and consumption and discourage saving.

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23
Q

What happens when real GDP changes versus when nonincome determinants change?

A

Changes in real GDP cause movement along the consumption and saving schedules.

Changes in nonincome determinants cause shifts in the schedules.

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24
Q

How do tax changes affect the consumption and saving schedules?

A

Higher Taxes: Shift both schedules downward.
Lower Taxes: Shift both schedules upward.

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25
Q

Why are consumption and saving schedules typically stable?

A

Long-term goals like retirement savings and emergency funds stabilize these schedules unless disrupted by major events.

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26
Q

What is the paradox of thrift?

A

Definition: Increased saving during a recession reduces spending, worsening the recession.

Irony: Individual households aim to save more, but collectively save less due to income declines.

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27
Q

How did the Pandemic Recession of 2020 illustrate the paradox of thrift?

A

Households saved more and consumed less, shifting the consumption schedule downward and saving schedule upward, which worsened the economic downturn.

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28
Q

What happens to the saving schedule when the consumption schedule shifts upward?

A

The saving schedule shifts downward.

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29
Q

What happens when taxes decrease?

A

Both the consumption schedule and saving schedule shift upward.

30
Q

What is the framework for investment decisions?

A

Investment decisions balance the expected rate of return (r) against the real interest rate (i). Firms invest where r > i.

31
Q

What does the expected rate of return (r) represent?

A

The anticipated profit percentage from an investment relative to its cost.

32
Q

How is the expected rate of return calculated?

A

r = ExpectedProfit / CostofInvestment
​
Example: $1,000 machine with $1,100 net revenue yields r = 10%.

33
Q

Why does investment involve risk?

A

Returns are not guaranteed, and actual profits may differ from expected profits.

34
Q

What is the real interest rate (i)?

A

The inflation-adjusted cost of borrowing, calculated as:

Realinterestrate = Nominalinterestrate − Inflationrate

35
Q

What is the rule for making investment decisions?

A
  1. Invest in all projects where r > i.
  2. Continue until r = i.
36
Q

What is the investment demand curve?

A

A curve showing the total monetary amount of investment demanded at various real interest rates.

37
Q

Why does the investment demand curve slope downward?

A

There is an inverse relationship between the real interest rate and the quantity of investment demanded. Lower i encourages more investment.

38
Q

How does inflation affect the real interest rate?

A

Inflation reduces the purchasing power of repaid dollars, effectively lowering the real interest rate and making investments more attractive.

39
Q

How do shifts in consumer factors affect the investment demand curve?

A

Changes in consumer wealth, expectations, household debt, or taxes can shift the curve.

40
Q

What is the relationship between the real interest rate and investment in the law of demand?

A

Lower i (borrowing cost) increases investment demand.

41
Q

What is the practical rule for businesses to decide on investment projects?

A

Analyze opportunities using the marginal-benefit–marginal-cost rule, and invest until
r = i.

42
Q

What happens to the investment demand curve when acquisition, maintenance, or operating costs increase?

A

Expected returns decrease → curve shifts left.

43
Q

How do lower business taxes affect the investment demand curve?

A

After-tax profitability increases → curve shifts right.

44
Q

How does technological change affect the investment demand curve?

A

Advances in technology increase productivity and profitability → curve shifts right.

45
Q

What happens when the economy is overstocked with capital goods?

A

Expected returns decrease → curve shifts left.

46
Q

How do planned inventory changes affect the investment demand curve?

A
  1. Planned inventory increase (expecting higher sales): Curve shifts right.
  2. Planned inventory decrease (expecting lower sales): Curve shifts left.
47
Q

How do optimistic business expectations impact the investment demand curve?

A

Expected returns increase → curve shifts right.

48
Q

Why is investment considered unstable?

A

It is highly volatile and fluctuates due to:

  1. Variability of expectations.
  2. Durability of capital goods.
  3. Irregularity of innovation.
  4. Variability of profits.
49
Q

How does the durability of capital goods contribute to investment instability?

A

Firms can delay replacing equipment, making investment discretionary.

50
Q

How do high current profits influence investment?

A

High profits generate optimism and funds for investment → increased investment.

51
Q

What role does innovation play in investment instability?

A

Major innovations trigger waves of investment but occur irregularly.

52
Q

What is the main component of economic fluctuations in output and employment?

A

Investment demand shocks caused by volatility in investment.

53
Q

What is the multiplier effect?

A

It is the phenomenon where an initial change in spending leads to a larger change in GDP.

54
Q

What is the formula for the multiplier?

A

Multiplier= ChangeinRealGDP / InitialChangeinSpending

​

55
Q

How can the change in real GDP be calculated using the multiplier?

A

ChangeinRealGDP=Multiplier × Initial

56
Q

If investment increases by $30 billion and GDP increases by $90 billion, what is the multiplier?

A

Multiplier = 90/30 = 3

57
Q

What types of spending can trigger the multiplier effect?

A

Investment, consumption, net exports, and government purchases.

58
Q

How does the multiplier work in both directions?

A

Increase in spending → multiplied GDP increase.
Decrease in spending → multiplied GDP decrease.

59
Q

What are MPC and MPS, and how are they related?

A
  1. Marginal Propensity to Consume (MPC): Fraction of additional income spent.
  2. Marginal Propensity to Save (MPS): Fraction of additional income saved.
  3. Relationship: MPC + MPS = 1
60
Q

What is the multiplier formula based on MPC?

A

Multiplier= 1 / (1−MPC)

61
Q

What is the multiplier formula based on MPS?

A

Multiplier = 1 / MPS

​

62
Q

What is the relationship between MPS and the multiplier?

A

Inverse relationship:
Higher MPS → smaller multiplier.
Lower MPS → larger multiplier.

63
Q

In an example with MPC = 0.75 and MPS = 0.25, how does a $5 billion investment affect GDP?

A

Total GDP change = $20 billion.
Multiplier: 20 / 5 = 4

64
Q

How does a higher MPC affect the multiplier?

A

A higher MPC results in a larger multiplier because more income is spent at each round.

65
Q

How do taxes and imports affect the multiplier?

A

They reduce the multiplier effect by diverting spending away from domestic goods and services.

66
Q

What happens to the multiplier when inflation occurs?

A

Inflation reduces the impact of the multiplier on real GDP as higher prices decrease the real output purchased.

67
Q

What is the range of estimated multipliers in the U.S. economy?

A

Estimates range from 0 to 2.5 due to factors like taxes, imports, and inflation.

68
Q

Why does a smaller MPS lead to a larger multiplier?

A

A smaller MPS means more income is re-spent in each round, amplifying the GDP change.

69
Q

If the MPS is 0.2, what is the multiplier?

A

Multiplier = 1 / 0.2 = 5

70
Q

If the MPS is 0.33, what is the multiplier?

A

Multiplier = 1 / 0.33 = 3

71
Q

What does a large MPC imply for GDP growth?

A

A large MPC causes GDP to grow more significantly as spending decreases slowly in successive rounds.

Macro (16 decks)

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