Module 15 - Income Determination

Question 1

To assess the potential profitability of any investment a firm must consider

I. the marginal efficiency of investment
II. the rate of interest

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 1

The correct answer is C. The marginal efficiency of investment (MEI) specifies the cost of an investment and its expected returns. Thus the MEI will be considered by firms in contemplating a particular investment. For any activity to be economically viable the marginal benefits for undertaking it must exceed the marginal cost. In evaluating any investment the rate of interest indicates the cost of borrowing to finance an investment and also the opportunity cost of investment funds, i.e. what the funds owner could earn by lending these funds. Thus the rate of interest must be considered in investment decision making.

Question 2

Using the compound interest formula if a principal sum P0 were lent at interest rate R for two years the principal sum received at the end of two years P2 would be
P2 = P0(1 + R)(1 + R) or P2 = P0(1 + R)2

Which of the following is the principal to be received at the end of n years?

A. Pn = P0(1 + R) × n
B. Pn = P0(1 + R)n
C. Pn = n(1 + R)n
D. Pn = n(1 + R)

Answer 2

Question 3

Answer 3

Question 4

Which of the following is correct?

The diagram above indicates that the MEI

A. depends upon the interest rate R
B. becomes negative if R decreases from R2 to R1
C. declines as the value of investment undertaken increases
D. and R are in equilibrium only at a zero rate

Answer 4

The correct answer is C. The MEI indicates the rate of return for different levels of investment. It is independent therefore of R. Thus A is incorrect. R1 is associated with investment level OI1 and R2 is associated with investment level OI2. Both OI1 and OI2 are positive. Thus B is incorrect. In equilibrium investment level occurs where r = R; thus D is incorrect. The MEI is constructed by rank ordering investment opportunities from the highest rates of return to the lowest; thus the negative slope of MEI.

Question 5

Which of the following is correct?

If R were zero the equilibrium level of investment would be

A. OI0 or OI1 or OI2
B. OI0 only
C. Zero
D. Infinite

Answer 5

The correct answer is B. The equilibrium level of I occurs where MEI (r) = the rate of interest (R). It will always pay a firm to invest as long as MEI, the rate of return on an investment, is greater than R1, the cost of the investment. The MEI schedule intersects the horizontal axis, i.e. where R = zero, at I0. Thus if R were zero it would pay firms to invest up to the level at which r = 0 ; this occurs at I0.

Question 6

If r were zero this would indicate that

I. the rate of interest was zero
II. all investments with a positive r had been undertaken
III. the MEI function was a horizontal line

Which of the following is correct?

A. I and III only
B. II only
C. I, II and III
D. Not I, not II, not III

Answer 6

The correct answer is B. The MEI is drawn by rank ordering all investment opportunities from the highest return to the lowest. Thus III is not correct. Zero r indicates that the investment project has been reached where the rate of return is zero, thus II is correct. A zero r says nothing about R.

Question 7

If investment were completely interest inelastic, which of the following would be true?

A. The volume of investment would be constant
B. The volume of investment would not be much affected by changes in interest rates
C. The rate of interest would be relatively constant
D. The MEI schedule would be almost horizontal

Answer 7

The correct answer is B. Price elasticity of demand refers to the responsiveness of quantity demanded to changes in price. Interest elasticity of investment refers to the responsiveness of the volume of investment to changes in the interest rate. If the MEI is interest inelastic it will be represented by a vertical line indicating no responsiveness to interest rate change. Thus B is correct and D in incorrect. Other factors such as expectations by shifting the MEI schedule would have more significance in determining the level of investment; being interest inelastic would certainly not guarantee constant investment nor would it guarantee a constant rate of interest R, R being determined by the demand for and supply of money. Thus A and C are incorrect.

Question 8

Y ≡ C + I + G
C = .75Yd
Yd = Y − T

Assuming sufficient unemployed resources to allow all multiplier rounds to be completed.

Which of the following is the impact on Y of an increase in G of 10?

A. 10
B. 20
C. 30
D. 40

Answer 8

Question 9

Y ≡ C + I + G
C = .75Yd
Yd = Y − T

Assuming sufficient unemployed resources to allow all multiplier rounds to be completed.

Which of the following is the impact on Y of a decrease in I of 20?

A. 20
B. −20
C. −40
D. −80

Answer 9

The correct answer is D.

See after question 15.10 for full solution.

ΔI = −20  ∴ ΔY = 4 × −20 = −80

Question 10

Y ≡ C + I + G
C = .75Yd
Yd = Y − T

Assuming sufficient unemployed resources to allow all multiplier rounds to be completed.

Which of the following is the impact on Y of a decrease in T from 20 to 15?

A. −20
B. −15
C. +15
D. +20

Answer 10

The correct answer is C.

ΔT = −5 (i.e. decrease from 20 to 15) ∴ ΔY = − 3 × −5 = +15

Question 11

The slope of the MEI curve assumes that as the volume of investment increases the marginal efficiency of investment will decline. Over time, however, there is no empirical evidence to suggest that the rate of return over cost has declined. These apparently conflicting views can be resolved because

I. the slope of the MEI curve assumes technical knowledge is fixed in the short-run

II. the rate of interest has declined over time

III. advances in technology shift the MEI schedule to the right over time

Which of the following is correct?
A.I only
B. I and III only
C. I, II and III
D. Not I, not II, not III

Answer 11

The correct answer is B. When a firm is considering, and ranking, investment opportunities it is assumed that technical knowledge is given in this decision making period; if it were not the future income stream would be unknown. Therefore I is correct. The rate of interest is determined by the demand for and supply of money and fluctuates over time; thus II is incorrect. As technological change occurs, i.e. producing a given output with fewer resources the future income stream for any investment, where technological change occurs, will be higher than it was before. This will be reflected diagramatically by a rightward shift in the MEI curve. Thus III is correct.

Question 12

Which of the following factors will shift the MEI schedule to the left?

A. Anticipation of a world wide boom
B. Breakdown of world trade agreement and increases in tariffs and quotas
C. Decrease in raw materials prices
D. Research indicating higher than expected future returns

Answer 12

The correct answer is B. The MEI will shift to the right on ‘good news’ and the left on ‘bad news’. Good news is anything which makes the business climate better than, and economic activity higher than, previously predicted, e.g. return to political stability, exchange rate stability, technological change, falling factor input prices. Bad news indicates economic activity is not going to be as robust as previously anticipated; only B falls into the latter category. A, C and D are all ‘positive’.

Question 13

Which of the following factors will shift the MEI schedule to the right? Increase in

A. the degree of uncertainty regarding future returns
B. the rate of interest
C. the expected returns on investment
D. costs of doing business due to adherence to international standards

Answer 13

The correct answer is C. The MEI will shift to the right on ‘good news’ and the left on ‘bad news’. Good news is anything which makes the business climate better than, and economic activity higher than previously predicted, e.g. return to political stability, exchange rate stability, technological change, falling factor input prices. Bad news indicates economic activity is not going to be as robust as previously anticipated; A and D fall into the latter category. The rate of interest does not affect the position of the MEI schedule. C falls into the positive category.

Question 14

Which of the following is correct?

The accelerator principle assumes that some investment expenditures are associated with the rate of change of

A. the interest rate
B. national income
C. the multiplier
D. the marginal efficiency of investment schedule

Answer 14

The correct answer is B. This is a definitional question.

Question 15

The accelerator principle does not yield a comprehensive explanation of investment expenditure but it does deal with investment associated with

I. inventions and technological change
II. depreciation of the capital stock
III. changes in the rate of interest

Which of the following is correct?
A. I and II only
B. II and III only
C. I, II and III
D. Not I, not II, not III

Answer 15

Question 16

Which of the following values of the marginal propensity to consume and the accelerator combined will result in the smallest fluctuation in income, output and employment?

Answer 16

The correct answer is A. The higher the value of the MPC the larger the multiplier and therefore the greater the increase in income, output and employment from an exogenous increase in expenditure. Similarly the higher the capital – output ratio the larger the accelerator and the greater the fluctuation in economic activity from any increase in Y. Thus the combination of MPC and accelerator which will yield the smallest changes in income, output and employment will be that where the values are lowest.

Question 17

Y = C + I + G

C = 0.75yd

yd = y(1-t)

t = 0.2

Which of the following is the impact on Y of an increase in G of 10?

A. 10
B. 25
C. 50
D. 100

Answer 17

Question 18

Y = C + I + G

C = 0.75yd

yd = y(1-t)

t = 0.2

Which of the following is the impact on Y of a decrease in I of 20?

A. 0
B. −20
C. −50
D. −100

Answer 18

Question 19

Y = C + I + G

C = 0.75yd

yd = y(1-t)

t = 0.2

Which of the following is the impact on Y of an increase in G of 11 accompanied by an increase in the tax rate from 20% to 40%?

A. 11
B. 20
C. 22
D. 36

Answer 19

Question 20

An economy is suffering from high rates of unemployment. The following would stimulate the economy and make the unemployment rate lower than it otherwise would have been.

An increase in

I. Government expenditure
II. Imports
III. Exports
IV. Income taxes
V. Autonomous investment expenditure

Which of the following is correct?
A. I and V only
B. I, III and V only
C. II, III only
D. I, II, III, IV and V

Answer 20

The correct answer is B. An injection into the income stream is expansionary; any leakage/withdrawal from the income stream is contractionary. Consider Y≡C + I + G + X − Z Increase in I, G and X are clearly expansionary (thus I, III and V are correct) and an increase in imports is contractionary, (thus II is incorrect). An increase in tax will reduce disposable income and consequently consumption and thus will be contractionary, (thus IV is incorrect).

Question 21

Which of the following is correct?

A. Y = C + I + G
B. Y = C + I + G − T
C. Y = C + I + G + T
D. Y = (C + I + G + T) / 0.8

Answer 21

The correct answer is A. The value of national output, which equals national income (Y), is determined by the sum of consumption expenditure, investment expenditure,
and government expenditure, i.e. Y ≡ C + I + G.

Question 22

Which of the following is the equilibrium level of national income?

A. 2400.
B. 2750.
C. 2775.
D. 2875.

Answer 22

Question 23

Which of the following is true of the given simple economy?

A. The chief cause of unemployment is insufficient spending.

B. The equilibrium level of national income coincides with the full-employment
level.

C. Inflation and employment are negatively related.

D. Tax cuts are more powerful than government spending in increasing employ-
ment.

Answer 23

The correct answer is A. The basic proposition of the income–expenditure model is that the level of national income, and therefore the level of employment, is deter- mined by the level of aggregate demand. Hence unemployment arises because of insufficient aggregate demand.

Question 24

‘In public discussions about the current unemployment, policy makers have failed to appreciate the “multiplier effect”, namely the theory that $1000 million spending by government ultimately creates $2500 to $3000 million increase in GNP. But if this theory is true, it must work in reverse. The net effect of a $1000 million cut in govern-
ment spending today would be equivalent to a $2500 million to $3000 million increases
in taxes.’ Is the economic analysis in this quotation correct or incorrect, and why?

A. Correct, because government spending has a multiplier effect on consumption.

B. Incorrect, because an increase in taxes also has a multiplier effect.

C. Correct, because the value of the marginal propensity to consume determines
the size of the multiplier.

D. Incorrect, because a $1000 million cut in government expenditure would
decrease national income more than a $2500 to $3000 million increase in taxes.

Answer 24

The correct answer is B. A $1000 million cut in government expenditure would, through the multiplier effect, decrease GNP by some multiple amount, i.e. −G × multiplier = −GNP. The same multiplier process works for an increase in tax, i.e. T × multiplier = −GNP. If −G and T were of the same magnitude, e.g. $1000 million, the resultant decreases in GNP would differ by $1000 million; this is because the tax multiplier process would only begin with the decrease in consumption that results from the increase in tax, e.g. $750 million if MPC were 0.75.

Question 25

Which of the following is the basis of the accelerator principle?

A. Income is a function of investment.
B. Consumption is a function of income.
C. Saving is a function of income.
D. Change in net investment is a function of the rate of change of national income.

Answer 25

The correct answer is D. The accelerator principle assumes a fixed relationship between the capital stock and national output, which equals national income. Thus, a change in national income will produce a change in net investment expenditure.

Question 26

Which of the following could have caused the shift in the investment level from I1 to I2?

A. A decrease in the rate of interest.
B. An increase in the business tax rate.
C. An increase in the rate of interest.
D. Labour-saving innovations.

Answer 26

The correct answer is D. The upward shift of the investment function shown in Figure 15.16 has come about because of an increase in the return on investment. The rate of interest is merely the ‘price’ of investment; hence changes in the rate of interest affect the position on the curve, not the curve itself. Increases in business tax rates and wage rates will reduce the return on investment, but labour-saving innovations will increase the return on investment.

Question 27

In period 1 investment was 0i1 and it remained at that level in period 2, despite the shift
in the investment function. Which of the following could account for this?

A. The demand for replacement investment increased.

B. The rate of interest increased from 15 per cent to 20 per cent.

C. Firms delayed investment by the amount of i1i2.

D. Imports of investment goods increased.

Answer 27

The correct answer is B. The investment curve shows how much firms are willing to invest given the rate of interest. An increase in the rate of interest from 15 per cent to 20 per cent between time periods 1 and 2 would have compensated for the increased willingness of firms to invest in time period 2. Replacement investment is included in the investment curve, as is the timing of investment expenditure. The investment curve relates to the intentions of firms in the country; hence imports are irrelevant.

Question 28

The rate of interest was 15 per cent in period 1 and 10 per cent in period 2. Which of the following represents the change in investment between the two periods?

A. From 0i1 to 0i3.
B. From 0i2 to 0i3.
C. From 0i3 to 0i1.
D. From 0i2 to 0i1.

Answer 28

The correct answer is A. At a 15 per cent rate of interest, firms would be willing to invest 0i1 in time period 1. After the investment curve had shifted in period 2, firms would be willing to invest 0i3 at 10 per cent rate of interest.

Question 29

Which of the following will tend to cause an investment expenditure curve to shift downwards?

A. A new technological advance that cuts the price of primary steel by one half.

B. A significant decline in the rate of interest.

C. A decline in wage rates.

D. An increase in corporation tax.

Answer 29

The correct answer is D. A shift in the investment expenditure curve (the investment curve) occurs as a result of a change in some factor that affects the return on investment. Technological advance, and/or reduced wage costs and/or a reduction in corporation tax would cause the investment curve to shift upwards as, other things being equal, they would increase the rate of return expected from an investment. An increase in corporation tax would shift the investment curve downwards – that is, other things being equal, an increase in corporation tax would reduce the rate of return expected from an investment.

Question 30

The assumptions made in constructing the simple accelerator model are

I. businessmen ignore expectations in making investment decisions.

II. businessmen never allow their capital stock to become excessive or deficient in meeting their current demand for output.

III. small adjustments in capital stock are made by firms in facing minor output fluctua-tions. Which of the following is correct?

A. I only.
B. II and III only.
C. I and II and III.
D. Not I nor II nor III.

Answer 30

The correct answer is C. The simple accelerator model assumes that a fixed capital output ratio holds in all situations. In consequence, a given change in income will produce the same change in investment, whatever the rate of the economy. The simple accelerator model, therefore, views investment as an automatic process uninfluenced by expectations. Further, it assumes that there is never any excess capacity that would allow a firm to meet increased demand without new investment.

Question 31

There is considerable unemployment in the economy. The government is proposing to finance a $200 million increase in expenditure for goods and services with a $200 million increase in income taxes. If interest rates were kept unchanged and if consumers always spend 90 per cent of their after-tax income, such a scheme would do which of
the following:

A. raise national income.
B. leave national income unchanged.
C. lower national income by $280 million.
D. lower national income by $180 million.

Answer 31

The correct answer is A. The policy increases income through the balanced budget multiplier process. An increase in government expenditure accompanied by the same increase in taxation will raise the level of aggregate demand. In the first round, the increase in government expenditure increases the aggregate demand by the amount of the increase; subsequent multiplier effects are exactly offset by the multiplier effects from increased taxes.

Question 32

A government wishes to balance its budget, achieve full employment and distribute Y among C, I and G in certain proportions. The Chief Economic Adviser has advised that
at least one of the policy objectives should be dropped. Upon which of the following is his professional advice based?

A. The three objectives have different levels of importance.

B. Only by remote chance will values of Y, T, C, I and G occur that will achieve
the three objectives.

C. Balanced budgets are incompatible with full employment.

D. It is not possible to influence the distribution of GNP between C, I and G.

Answer 32

The correct answer is B. Suppose the budget was balanced, i.e. G = T, and that Y was distributed among C, I and G in the desired proportions, for example 60 per cent, 20 per cent and 20 per cent; also suppose that the economy was in equilibrium but operating at less than full employment. The achievement of full employment requires fiscal policy, i.e. an increase in G, a cut in taxes, or both. Once such a policy has been enacted, there is no guarantee that the new level of G will equal the new level of taxes, i.e. that the budget will still be balanced, and no guarantee that the original distribution of C, I and G will remain; this is because different fiscal actions will affect each of C, I and G by varying amounts. It is therefore incorrect that the distribution among C, I and G cannot be affected by policy. It is possible to have a balanced budget at full employment, but there is no guarantee that this will occur. The economist’s advice is therefore based on the fact that it is not possible to control all five variables, Y, T, C, I and G, simultaneously. The fact that the three objectives may have different levels of importance is no reason for dropping any one of them.

Question 33

If the government were to adopt a policy that led to households saving more of their income, which of the following effects would be felt on national income in the short run?

National income would

A. increase because saving equals investment and an increase in investment expenditure would lead to an increase in national income.

B. decrease because an increase in the willingness of households to save is not automatically matched by an increase in the willingness of businesses to invest.

C. increase because households will save more only if their incomes increase.

D. decrease because additional saving would force up interest rates which in turn would decrease investment expenditure.

Answer 33

The correct answer is B. If households were to save more of their income, then in the short run they would consume less of their income. Businesses would find inventories (stocks) accumulating because their production plans would be geared to the former higher levels of consumption expenditure. They would cut back on production to eliminate the unintended inventory accumulation, thereby reducing national income and increasing unemployment.

Question 34

Which of the following explains why a progressive tax acts as an ‘in-built stabiliser’?

A. When GNP changes, the government changes tax rates.

B. When GNP changes, tax rates change automatically.

C. Tax collections increase as government spending decreases.

D. When GNP changes, tax receipts change automatically in the same direction
without any change in tax rates.

Answer 34

The correct answer is D. An in-built stabiliser is an element of demand that changes automatically in an anticyclical fashion, thus helping to stabilise national income. An in-built stabiliser could be any form of taxation that increases automatically when income rises and falls automatically when income falls. A progressive tax has this property, since high marginal tax rates result in a higher proportion of income being collected as income increases, and vice versa.

Question 35

Which of the following is correct?

The function of an ‘in-built stabiliser’ is to

A. ensure that the same amount of tax is collected each year.

B. balance the budget each year.

C. reduce fluctuations in economic activity.

D. ensure that government expenditure is the same each year.

Answer 35

The correct answer is C. An in-built stabiliser ensures that when economic activity increases, proportionately more spending power is leaked out into taxation, and when economic activity declines, proportionately less tax is leaked out. As a result, in-built stabilisers tend to reduce fluctuations in economic activity. Thus in-built stabilisers do not ensure that tax collected and government expenditure are the same, nor that the same amount of tax is collected each year.

Question 36

Which of the following is correct?

The importance of the international sector for the level of national income is that

A. an excess of exports over imports results in a leakage from the circular flow.

B. unless exports are greater than imports, the national income will continuously decline.

C. the excess of exports over imports determines the rate of growth of the economy.

D. imports are leakages from and exports injections to the circular flow.

Answer 36

The correct answer is D. Imports are the demand for goods and services produced in other economies and are a withdrawal from the circular flow. Exports are the demand by foreigners for goods and services produced within the domestic econo- my and are an injection into the circular flow. Since Y = C + I + G + X − Z, Y can continue to grow when Z > X as long as the growth in C + I + G exceeds the growth in the difference between Z and X.

Question 37

In order to calculate the value of the government expenditure multiplier, it is essential to know

I. the marginal propensity to import.

II. government expenditure.

III. the marginal tax rate.

Which of the following is correct?

A. I and II only.
B. I and III only.
C. II and III only.
D. II only.

Answer 37

The correct answer is B. The value of the multiplier depends on the leakages from the circular flow of income. The marginal propensity to import and the marginal tax rate are both leakages. The value of government expenditure does not affect the value of the multiplier.

Question 38

Consider the following statements.

I. An increase in import expenditure reduces GNP.

II. A reduction in export expenditure increases GNP.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 38

The correct answer is A. National income = C + I + G + X − Z. Thus an increase in Z will make national income lower than it otherwise would have been; a decrease in X would have the same effect.

Question 39

In an economy it was found that the marginal propensity to consume is 0.8. The government economic adviser therefore calculated the multiplier to be 5 (i.e. 1/(1 −
0.8)). An increase in exports of $10 billion took place and it was found that national income increased by $20 billion. National income did not increase by the full value of the multiplier times the increase in exports, i.e. by $50 billion, because

I. the marginal propensity to import may have been greater than zero.

II. the marginal propensity to save was not included in the information, and may have
been greater than zero.

III. imports and exports became equal after national income was increased by $20 billion.

Which of the following is correct?

A. I only.
B. I and II only.
C. I and III only.
D. II and III only.

Answer 39

The correct answer is A. Calculation of the multiplier must take into account all leakages, including the marginal propensity to import, therefore I is correct. The marginal propensity to save is 1 − MPC, hence it was implicitly used to calculate the multiplier; therefore II is incorrect. Equality of exports and imports does not set a constraint on the level of national income, therefore III is incorrect.

Question 40

An economy was experiencing a decreasing GNP, and many people blamed the increased competition of imports and the increased willingness of consumers to buy
imported goods. However, when the national accounts for the year were published, it was found that both GNP and imports had fallen. Which of the following could account for this?

A. Exports had increased.

B. Investment demand had increased.

C. Fewer imports were bought in total because of a reduction in aggregate
demand.

D. The marginal propensity to consume had increased.

Answer 40

The correct answer is C. The level of GNP can fall for a number of reasons – for example, a reduction in investment demand, a reduction in export demand, or a reduction in consumer demand. Hence an increase in exports, an increase in consumption, or an increase in investment demand, could not account for a reduction in imports. At the lower level of GNP, customers could buy less imports despite the fact that the marginal propensity to import had increased.