lecture 3 Flashcards
What does the consumption function describe, and what are its components?
The consumption function describes the behavior of consumers and is a linear relationship between consumption (C) and disposable income (Yd). It consists of:
* c1 (marginal propensity to consume): The effect of an additional dollar of disposable income, 0 < c1 < 1.
* co (intercept): The base level of consumption when disposable income is zero, co > 0.
What is meant by autonomous spending in the goods market?
Autonomous spending refers to the part of total demand that does not depend on the level of output. It includes government spending, investment, and consumption, which are largely determined by factors other than the current income.
What is the role of investment (I) in GDP composition, and how is it determined?
Investment is the purchase of capital goods and is an exogenous variable, meaning it is determined outside the model (not directly influenced by the economy’s output level). It impacts GDP by increasing the demand for goods and services.
How does an increase in autonomous spending affect the economy in the goods market?
An increase in autonomous spending shifts the demand curve to the right, which leads to higher production and higher income. This process continues through a multiplier effect, with income increasing in stages (A → B → C → D → E) as demand rises.
What does the IS relation in macroeconomics describe?
The IS relation represents the equilibrium condition for the goods market. It states that investment must equal savings (private + public). This balance ensures that what firms invest matches the amount people and the government wish to save.
What is the paradox of saving in an economy?
The paradox of saving occurs when individuals try to save more, which causes a decrease in overall output while leaving total savings unchanged. As private savings increase, income (Y) falls, leading to a reduction in consumption, which neutralizes the intended increase in savings.
How does savings behavior influence consumption and output in the economy?
The decision to save or consume is interconnected. The marginal propensity to save is (1 - c1), where c1 is the marginal propensity to consume. As consumers save more, consumption falls, and if consumption declines too much, total demand drops, which can lead to lower output.
Explain the process of adjusting output in response to increased demand.
When consumers increase their demand, the initial planned production by firms might not be sufficient. Firms gradually increase production over time to meet the rising demand, leading to a slow adjustment toward the new equilibrium as c1 and co increase, reflecting the higher demand.
How does the government’s budget surplus or deficit impact the economy?
- Budget surplus: Occurs when T > G (tax revenue exceeds government spending). This can lead to reduced government debt.
- Budget deficit: Occurs when T < G (spending exceeds tax revenue), increasing public debt. A persistent deficit can limit government flexibility in future fiscal policy and may lead to inflationary pressures.
