Chapter 11: Income and Expenditure

Question 1

Initial Assumptions re: how change in agg. spending –> change in income–> more change in aggregate spending

Answer 1

Initial Assumptions:

1. Producers willing to supply additional output at a fixed price (w/o driving up level of prices) then, changes in agg. spending –> changes in output (in terms of real GDP)
2. Interest rate is given
3. Govt spending/taxes = 0
4. Exports, imports = 0

Question 2

Marginal Propensity to consume (MPC)

Answer 2

1. = the increase in consumer spending that occurs if current disposable income goes up by $1.
2. = Chg in consumer spending/change in disposable income. and = chg in consumer spending – change in disposable income.
3. Always a number between 0&1.
4. MPC increases if MPS increases
5. = the proportion of total disposable income that average family consumes
   6.

Question 3

Marginal Propensity to save (MPS)

Answer 3

1. = fraction of an additional $1 of disposable income that is saved.
2. = (1-MPC)

Question 4

The multiplier:

Answer 4

= [1/1(1-MPC)]
Thus, change in real GDP =
[1/1(1-MPC)] x (chg in autonomous aggregate spending).

Question 5

autonomous change in aggregate spending

Answer 5

= in an initial change in the desired level of spending by firms, households or govt at a given level of real GDP.

Change in Y =
1/1-MPC x ChangeAAS

Question 6

The multiplier

Answer 6

= is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change.

Multiplier = chg in Y/chg AAS
= 1/1-MPC

Question 7

Consumption Function:

Answer 7

1. shows how a household’s consumer spending varies w/ the household’s current disposable income
2. c = a + MPC x yd
   c=ind. household consumer spending
   a = indiv. autonomous consumer spending a household would do if its disposable income = 0
   yd = individual household current disposable income
   Both a and yd are assumed to be constant.

Question 8

Slope of consumption function

Answer 8

= rise over run
= Chg in c/Chg in yd
= MPC x Chg in yd/chg in yd
= MPC

Question 9

In the consumption function

Answer 9

An ind. household’s consumer spending is:

• +related to current disposable inc.
• -related to autonomous consumption and it’s MPC
• +related to the interest rate
• determined by accelerator principle

Question 10

Aggregate consumption function

Answer 10

1. shows the relationship between the aggregate disposable income in an economy and the level of aggregate consumer spending.
2. C = A + MPC x YD
   C = aggregate consumer spending
   A = aggregate autonomous consumer spending
   YD = aggregate disposable income.
3. C = a positive relationship bet. the level of aggregate consumer spending and the level of aggregate disposable income.

Question 11

Causes of shifts in aggregate consumption function

Answer 11

chgs in expected future disposable income and wealth.

Question 12

Life-cycle hypothesis

Answer 12

Consumers plan their spending over a lifetime, and as a result try to even out their consumption spending over the course of their entire lives.

Question 13

Permanent income hypothesis

Answer 13

consumer spending is ultimately dependent on the income people expect to have over the long term rather than on their current income.

• an increase in expected future disposable income or wealth causes the vertical intercept, A, to increase and this results in an upward shift of the aggregate consumption function.
• similarly, a decrease in expected future disposable income or wealth causes the aggregate consumption function to shift down

Question 14

Econometrics

Answer 14

use of statistical techniques to analyze the fit between economic models and empirical data.

Question 15

Level of investment spending

Answer 15

1. critical determinant of economic performance: most recessions result from a decrease in investment spending

Question 16

Investment spending

Answer 16

1. spending that businesses plan to undertake during a given period.
2. Depends negatively on:
   *interest rate (inversely related)
   *existing production capacity
   and

positively on:
*expected future real GDP.

Question 17

Level of interest rates

Answer 17

determines whether or not a firm will undertake a particular investment projects. If rate of return = or > interest rate, then project will be funded; if rate of return < interest rate, will not be funded

Question 18

Accelerator principle

Answer 18

1. a higher rate of growth in real GDP –> higher planned investment spending due to rapid growth in sales using up any excess productive capacity
2. a lower growth rate of real GDP –> lower planned investment spending.

Question 19

Retained earnings

Answer 19

past profits used to finance investment spending

Question 20

Inventories

Answer 20

stock of goods that firms hold to satisfy future sales.

Question 21

Inventory investment

Answer 21

value of the chg in total inventories held in the economy during a given period

Question 22

Unplanned inventory investment

Answer 22

occurs when actual sales are > or < than businesses expected, leading to unplanned changes in inventory

Question 23

Actual investment spending (I)

Answer 23

I = I (unplanned) + I (planned)

the sum of planned investment spending and unplanned inventory investment

Question 24

In a closed economy with no govt and a fixed agg. price level, there are only 2 sources of aggregate demand (AD)

Answer 24

1. consumer spending
2. investment spending
   so YD (agg disposable inc) = GDP

Question 25

Total AE (Planned agg spending)

Answer 25

= consumption spending, C, and planned investment (I planned)

Question 26

Slope of AE (Planned)

Answer 26

= MPC

Question 27

AE(Planned) may differ from GDP

Answer 27

bec of influence of unplanned Agg spending in form of unplanned inventory investment

Question 28

over time economy moves to “income-expenditure equilibrium”

Answer 28

or where AE(planned) = GDP

Question 29

AE(planned)>GDP or Y

Answer 29

unplanned inventory investment is negative; there is an unanticipated reduction in inventories and firms increase production

Question 30

AE(planned)<GDP or Y

Answer 30

I (unplanned) is positive: inventories increase, signalling firms to decrease production

Question 31

GDP = AE (planned)

Answer 31

economy is at income-expenditure equilibrium; I(unplanned) = 0, and no incentive to change level of production
C = A + MPC x YD
AE (planned) = C + I (planned)

Question 32

Keynesian Cross diagram (crosses the 45 degree line)

Answer 32

diagram that ids the income-expenditure equilibrium GDP where AE(Planned) = GDP; the macroeconomy self-adjusts when GDP is not = AE(planned) through inventory adjustment

Question 33

AE line or AE (planned)

Answer 33

shifts if chg in planned investment spending or shift in C, consumption function. Either shift triggers the multiplier effect
Multiplier = 1/(1-MPC)

Question 34

Paradox of Thrift

Answer 34

1. households and firms cut their spending in anticipation of future tough economic times.
2. These actions depress the economy, leaving households and firms worse off than if they had acted in the first place.
3. Called a paradox because what is usually good is bad.