Chapter 4

Question 1

What is desired consumption?

Answer 1

Consumption amount desired by households

Question 2

What is desired national

Answer 2

Level of national saving when consumption is at its desired level
Sd = Y - Cd - G

Question 3

What is the consumption and saving model?

Answer 3

A person can consume less than their income (saving)
A person can consume more than their current income (dissaving)

Question 4

What is the trade-off between current consumption and future consumption?

Answer 4

The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate

Question 5

What is consumption-smoothing?

Answer 5

The desire to have a pattern of consumption over time

Question 6

What is the substitution effect?

Answer 6

Change in consumption patterns due to a change in the relative prices of present and future goods as measured by interest rate

Question 7

What is the wealth effect?

Answer 7

Change in consumption patterns due to a change in purchasing power

Question 8

What is the graph for the substitution effect?

Answer 8

W and N
MPN shifts to the right
Supply stays

Question 9

What is the graph for the wealth effect?

Answer 9

W and N
Supply shifts to the left
MPN remains

Question 10

What are the effects of changes in current income?

Answer 10

Increases in current income - consumption and saving increase
MPC = fraction of additional current income consumed in current period - between 0 and 1
Higher expected future income = greater wealth leads to more consumption today, so saving rates fall

Question 11

What effect does increases real interest rate have?

Answer 11

Substitution effect: positive effect on savings, rate of return is higher and greater reward for saving elicits more saving
Wealth effect:
For saver: - effect since less saving to obtain a given amount in future
For a borrower: + effect since higher real interest rate mens loss of wealth

Question 12

What is the fiscal policy?

Answer 12

Government purchases:
Higher G financed by higher taxes reduces after-tax income, lowering desired consumption
Reduces both desired consumption and desired national saving if taxes are considered by individuals

Question 13

What is the economic role of investment?

Answer 13

Fluctuates sharply over the business cycle
Adds to the capital stock:
- desired capital stock is the amount of capital that allows firms to earn the largest expected profit
- desired capital stock depends on costs and benefits of additional capital
- since investment becomes capital stock with lag, benefit of investment if the future MPK

Question 14

What factors shift the MPK curve?

Answer 14

Changes in real interest rate
Depreciation rate
Price of capital
Technology changes that affect MPK

Question 15

What is the graph for a reduction in the demand for capital?

Answer 15

MPK shifts to the left
r and K

Question 16

Taxes and desired capital stock

Answer 16

Profits are taxed
Depreciation allowances reduce tax paid by firms since they reduce profits
Investment tax credits reduce taxes when firms make new investments

Question 17

What is the tax-adjusted yield?

Answer 17

r(1-t)
Increase in t reduces the tax-adjusted real interest rate
Reduces the desired capital stock

Question 18

What is the savings and investment market?

Answer 18

Savings curve, S
Investment curve, I
r and desired national savings and investment

Question 19

What are the shifts in the saving curve?

Answer 19

Shifts to the right due to rise in current output, fall in expected future output, fall in wealth, fall in government purchases, rise in taxes

Question 20

What are the shifts in the investment curve?

Answer 20

Shift right due to fall in effective tax rate or a rise in expected future MPK