Chapter 3: National Income

Question 1

How households use income?

Answer 1

Pay taxes
Consume goods and services
Save through the financial markets

Question 2

How governments use income?

Answer 2

Pay for government purchases

Question 3

How firms use revenue?

Answer 3

Pay for factors of production

Question 4

Define public saving

Answer 4

Any excess of tax revenue after government spending. Which can either:
- budget surplus: positive
- budge deficit: negative

Question 5

What economy output of goods and services (GDP) depends on?

Answer 5

Its quantity of input (factors of production)

Its ability to turn inputs to outputs (production function)

Question 6

Define factors of production. Define its 2 important factors

Answer 6

Inputs used to produce goods and services.

The 2 most important factors:
- capital: set of tools that workers use
- labor: time people spend working

Question 7

Define production function

Answer 7

How much output is produced from given amounts of capital and labor.

Question 8

Define constant returns to scale

Answer 8

Property of production function where an increase in all factors results in an equal increase in output.

Question 9

What the factors of production and production function determine?

Answer 9

National income
Economy’s output

Question 10

Define factor prices.
Define 2 important factor prices.

Answer 10

Amount paid to each unit of the factors of production.

Important are:
- wage
- capital rent

Question 11

Define competitive firm

Answer 11

Firm that has no effects on market prices. So it is a price taker.

Question 12

Profit depends on what? How can competitive firm maximize profit?

Answer 12

Profit depends on product price, factor prices, factor quantitites.

A price-taker firm takes product and factor price from the market, and decide the profit maximizing factor quantity.

Question 13

Define diminishing marginal product

Answer 13

The marginal product of X decreases as the amount of X increases (holding other factors fixed)

Question 14

Define marginal product of labor

Answer 14

Extra amount of output produced when we increase the labor by 1 unit.

Question 15

How a competitive firm decides to increase the quantity of factors of production?

Answer 15

It compares extra revenue VS extra costs from hiring additional labor.

As long as revenue > cost it will increase

Question 16

Define real wage

Answer 16

Payment to labor measured in units of production instead of dollars.

Question 17

Define marginal product of capital

Answer 17

Amount of extra output firm gets when it increasing the capital by 1 unit.

Question 18

Define rental price of capital

Answer 18

Rental price measured in units of goods produced instead of dollars.

Question 19

Define consumption function

Answer 19

Higher level of disposable income leads to higher level of consumption

Question 20

Define MPC
What it equals?

Answer 20

Marginal product to consume is the amount by which consumption changes when disposable income increases by $1

It equals the slope of consumption function

Question 21

Define interest rate
What happens when interest rate rises?

Answer 21

Cost of funds used to finance investment

When interest rate rises, its more costly to launch projects, therefore less investment.

Question 22

What is the difference between nominal & real interest rate?

Answer 22

Real interest rate takes into account inflation

Question 23

Define fiscal policy

Answer 23

Policy that encompasses the government’s decisions about spending and taxation.

Question 24

What insures that the sum of consumption, investment, government purchases == amount of output produced?

How?

Answer 24

Interest rate.

Higher interest rate leads to lower demand for goods and services

Lower interest rate leads to higher demand for goods and services

Question 25

Define national saving.
What are the demand and supply for loanable funds?

Answer 25

National saving = private saving + public saving.

Saving is the supply of loanable funds.
Investment in the demand for loanable funds.

Question 26

How increase in government spending affects the economy?

Answer 26

Increase in demand, but factors in production are fixed. Then something else needs to decrease which is investment!

How to reduce investment? We increase interest rate!

Question 27

How decrease in taxes affects the economy?

Answer 27

Increase in disposable income which raises consumption.

High marginal propensity to consume must be met with reduction in investment sector.

We must increase interest rate to reduce investment.