Economics Chapter 17

Question 1

3 central macroeconomic flaws

Answer 1

Total production (or output)
Total income
Total spending (or expenditure)

Question 2

Simple Keynesian model

Answer 2

The “Keynesian” in the name of the model refers to the famous British economist, John Maynard Keynes, who developed the idea that total output and income are essentially determined by total spending (or total demand) in the economy

Question 3

National accounts

Answer 3

The national accounting system is essentially a bookkeeping system which is used to measure economic activity after it has occurred

Question 4

Production, income and spending

Answer 4

Total production(output) is always equal to total income
In national accounts total spending(expenditure) is always equal to the total production or income

Question 5

When does equilibrium occur?

Answer 5

Equilibrium occurs when none of the participants have any incentive to change their behavior. Things will therefore remain the same (as long as the underlying forces do not change)

Question 6

How can spending exceed income?

Answer 6

Households and firms can use savings from a previous period to finance their spending or they can purchase goods and services on credit.

Question 7

How can spending be less than income?

Answer 7

This happens when part of the income is saved and those savings do not find their way back into the circular flow of production, income and spending. Saving is a leakage or withdrawal from the circular flow

Question 8

A=Y

Answer 8

Spending may be equal to production and income
– there is no tendency to change

Question 9

A>Y

Answer 9

Spending may be greater than production and income.
Decrease in inventories. Incentive to increase production.

Question 10

A<Y

Answer 10

Spending may be less than production and income. Not making their way into the circular flow of production.
Increase in inventories, incentive to decrease production

Question 11

Say’s law

Answer 11

According to Say’s law, all leakages will automatically find their way back into the circular flow of income and spending. If this happens, total spending will always be equal to total income. According to Say’s law there can never be an insufficient demand for goods and services in the economy

Question 12

Say vs Keynes

Answer 12

Whereas Say believed that aggregate production or supply (Y) creates its own demand (A), Keynes claimed that aggregate demand (A) is the force which determines total production or income (Y)

Question 13

Assumptions vs Implications

Answer 13

A:The economy consists of households
and firms only.
I:Total spending consists of consumption spending and
investment spending.
A:There is no government
I:The model cannot be used to analyze government spending
or taxes.
A:There is no foreign sector.
I:The model cannot be used to analyze exports, imports,
exchange rates, trade policy and exchange rate policy.

Question 14

Assumptions vs Implications

Answer 14

A:Prices are given.
I:The model cannot be used to study inflation
A:Wages are given
I:The model cannot be used to study the workings of the labor
market.
A:The money stock and interest rates are
given.
I:The model cannot be used to study the financial markets or
monetary policy.
A:Spending (demand) is the driving force
that determines the level of economic
activity.
I:Production (supply) adjusts passively to changes in spending
(demand)

Question 15

Consumption function

Answer 15

The relationship between consumption expenditure by households and total income is called the consumption
function

Question 16

What do households spend on

Answer 16

Non-durable(food) and services
Semi-durable(furniture and clothing)
Durable goods

Question 17

Non-durable

Answer 17

Greatest contributor and most stable component of total consumption spending

Question 18

Semi(clothing) and durable(furniture)

Answer 18

Are less stable and can be largely influenced by other factors(income or availability of credit)
Total consumption expenditure is relatively stable and high proportion of total income in the economy

Question 19

The consumption function has three important characteristics

Answer 19

1)Consumption increases as income increases
2)Consumption is positive even if income is zero
3)When income increases ,consumption increases but the increase in consumption is less than the increase in income

Question 20

Autonomous vs induced consumption

Answer 20

A:is that part of consumption which is independent of the level of the income. Minimum level of consumption that is financed from sources other than income, past savings or credit
I:Component which is determined by the level of income

Question 21

Marginal propensity

Answer 21

The ratio between the change in consumption (ΔC) and the change in income (ΔY) is one of the most important ratios in macroeconomics. It is called the marginal propensity to consume and it is usually indicated by the symbol c. Note that it is equal to the slope of the consumption function. Measurement of the slope of the consumption function

Question 22

Marginal propensity

Answer 22

c=ΔC/ΔY

Question 23

The position of consumption

Answer 23

As indicated above, the position of the consumption function is determined by the level of autonomous consumption
The position of the consumption function is determined by all non-income factors that affect consumption spending, (i.e. the factors that determine autonomous consumption). These include the distribution of income, the age distribution of the population, consumers’ holdings of financial assets and the availability and cost of consumer credit

Question 24

What does the induced consumption depend on?

Answer 24

The marginal propensity to consume(c) which gives the slope of the consumption function
the level of income(Y)

Question 25

Investment spending

Answer 25

Spending by firms is referred to as investment spending(I)
Also called capital formation is less predictable and more volatile than consumption spending, causes major fluctuations in the economy
It involves the purchase of capital good (buildings, machinery and equipment)
Autonomous to income

Question 26

Determinant of investment spending

Answer 26

Investment decision-inform us about investment determinant
Firms invest because they hope to earn profits(the greater the expected profit, the greater the investment)

Question 27

What is expected profit depended on

Answer 27

Dependent on the cost of investment and revenue
Borrowing(interest rates)
Even if the firm buys the capital good cash it still needs to consider the opportunity cost of using those funds

Question 28

Investment decision

Answer 28

Inform us about investment determinant it is based on cost of capital goods, interest rates and expected revenue
other determinants are expected profits and business confidence
Involves three important variables: the cost of the capital goods, the interest rate and the expected revenue to be earned from the capital goods

Question 29

Multiplier

Answer 29

The ratio between the eventual change in income and the initial investment is called the multiplier. The size of the multiplier depends on the fraction of the additional income generated in each round that is spent in the next round, that is, on the marginal propensity to consume (c).
The ratio between the change in income and the change in autonomous spending (‘Y/’A) is called the multiplier.

Question 30

Multiplier

Answer 30

To obtain the change in income (ΔY) we therefore have to multiply the change in investment spending (ΔI) by
1/(1 – c)
The greater the marginal propensity to consume, the greater the multiplier will be

Question 31

The equilibrium level of income is obtained how

Answer 31

We can also write ΔY = a(ΔA) which is simply another way of stating that the change in income will be equal to the multiplier times the change in autonomous spending.

Question 32

Income vs Autonomous spending

Answer 32

The increase in income (‘Y) is greater than the increase in autonomous spending (‘A).