Module 4

Question 1

Consumption
The four building blocks of consumption are:
Are each positively or negatively related?

Answer 1

Current income - POSITIVE
Wealth - POSITIVE
Expected future income - POSITIVE
The interest rate on savings and borrowing - NEGATIVE

Question 2

What is autonomous expenditure and what’s its effect on a graph?

Answer 2

Expenditure that is not affected by the current level of income in the economy.

After all, people need to consume food, water and pay utilities even if they have zero income. These basics are autonomous expenditures that do not vary with aggregate income

On a graph, the function will start above zero and not at the origin

Question 3

Why is the savings function negative at x=0?

What is the space between the origin to the savings function called?

Answer 3

The savings function is negative at x=0 because of autonomous expenditures. People need to spend money, even if they haven’t earned any, so it chips into their savings.

The space is called DISSAVING

Question 4

Induced expenditure

Answer 4

The rise in consumption from an increase in disposable income

Question 5

Marginal Propensity to Consume (MPC)

How is it calculated?

Answer 5

MPC is the willingness of a person to consume, after a change in disposable income

MPC = ∆consumption ÷ ∆disposable income

Question 6

Marginal Propensity to Save (MPS)

How is it calculated?

Answer 6

MPS is the willingness of a person to save, after a change in disposable income

MPS = ∆savings ÷ ∆disposable income

Question 7

What is the relationship between MPS and MPC

Answer 7

Since disposable income can only be spent or saved, the relationship between MPS and MPC is: MPS + MPC = 1

Question 8

What is Wealth? How does a change in wealth affect consumption

Answer 8

Wealth can be from savings accounts, checking accounts, holdings of stocks, bonds, mutual funds and the value of houses

Wealthier households tend to consume more, and lower wealth households tend to consume less

POSITIVELY RELATED

Question 9

Is wealth a good predictor of Marginal Propensity to Consume (MPC)

Answer 9

No because research has shown us that both poor and wealthy households can have high MPC

Poor households have low income, so they spend whatever they earn
Wealthy households have money tied up in illiquid assets, so they often spend their paycheques

Question 10

Effect of Expected future income on consumption

Answer 10

If you expect a higher future income, then you are more likely to dip into savings to fund current consumption
If you expect to have a lower future income to be lower, then you are likely to reduce current consumption in order to save more for later

POSITIVELY RELATED

Question 11

Effect of Interest rate, or price of money, on consumption

Answer 11

A higher interest rate generally encourages saving, and heightens the cost of borrowing, which in turn decreases consumption

NEGATIVELY RELATED

Question 12

Determinants of Investment: Expected future profitability

Answer 12

Innovations that open up new spheres for investment attract high amounts of investment in physical capital.

For example, the tech boom in the 1990s spiked a massive increase in investment in computer equipment and software

POSITIVELY RELATED

Question 13

Determinants of Investment: Interest Rate

Answer 13

A significant way businesses invest is by borrowing financial capital. A primary determinant of investment then, is the interest rate (real interest rate) because it is the cost of borrowing capital

NEGATIVELY RELATED

Question 14

Determinants of Investment: Business Taxes

Answer 14

Business taxes are essentially extra costs associated with investment (reducing profits), and when business taxes rise, it becomes more expensive to invest

NEGATIVELY RELATED

Question 15

Is government spending affected by macroeconomic factors in the short term?

Answer 15

In the SHORT TERM, government spending is NOT AFFECTED by standard macroeconomic factors such as aggregate income, wealth and the interest rate
Direct transfers are not included in the calculation of government spending and only includes purchases of goods and services

Question 16

Effect on Net Exports: Domestic Income

Answer 16

Domestic income is that income earned within a country, so when income in a country rises consumption rises with it

An increase in consumption also leads to an increase in imports (along with locally produced goods and services). Since imports decrease net exports, we conclude that domestic income and net exports are usually NEGATIVELY CORRELATED

Question 17

Effect on Net Exports: Foreign Income

Answer 17

As income in foreign countries increases, so does consumption. Thus, higher consumption leads to more exports for the domestic country and higher net exports

POSITIVELY CORRELATED

Question 18

What do exchange rates tell us about?

Answer 18

Represent the value of goods in one country expressed in terms of the same goods in another country

Question 19

Effect on Net Exports: Exchange Rates

Answer 19

When real exchange rates increase, domestic goods become more expensive than foreign goods, which increases imports and decreases exports

NEGATIVELY CORRELATED

Question 20

Effect on Net Exports: Tastes for Foreign Goods

Answer 20

When tastes for foreign goods increase, the level of imports also increases. Since high imports lead to lower net exports, tastes for foreign goods are negatively correlated with net exports

Question 21

Effect on Net Exports: Trade policies

Answer 21

Changes in trade policies are reflected in exchange rates and other macroeconomic factors, rather than affecting net exports directly. Although, trade policies can be analyzed on a case-by-case basis for their direct effect on net exports

DEPENDENT ON SITUATION

Question 22

John Maynard Keynes pointed out that firms don’t produce what they can at a given price…

Answer 22

They produce what they can sell

Question 23

Planned Investment

Answer 23

The amount that firms actively choose to put into new capital resources and inventory accumulation

Question 24

Actual Investment

Answer 24

Is the amount of new capital investment and ACTUAL inventory changes.

Changes in inventory are included in investment, so when firms draw down on existing inventories, their actual investment becomes NEGATIVE. On the flip side, when firms accumulate new inventories the actual investment is POSITIVE

Question 25

If actual inventories exceeded planned inventories, then what would have happened? (Hint: demand levels)

Answer 25

There was a higher expected demand than what actually materialized

Question 26

Planned Aggregate Expenditure (PAE) - What does it consist of and how is it calculated?

Answer 26

We can decompose PAE–the level of aggregate expenditure that consists of consumption, government spending, planned investment and net exports with the below equation

PAE = A + bY

A = a constant that represents the autonomous sources of spending (not directly affected by income)
b = a positive coefficient that relates spending to national income
Y = national income

Question 27

Do national income, national production, planned aggregate expenditure and total output all represent the same thing?

Answer 27

Yes

Question 28

What is the Keynesian Equilibrium?

Answer 28

Where planned aggregate expenditure is equal to actual aggregate expenditure. It represents the situation where firms don’t need to change their output levels in response to a gap in planned and actual inventories

We can find the Keynesian equilibrium by drawing an additional 45° line representing all the equilibrium points where planned and actual aggregate expenditure are equal (PAE = Y)

Question 29

Non-income determinants effect on equillibrium aggregate expenditure

Will a PAE curve be higher or lower with higher/lower interest rates, business optimism and government spending?

Answer 29

A PAE curve will be higher than average in an economy with low interest rates, high business optimism and high government spending

A PAE curve will be lower than average in an economy with high interest rates, low business optimism and low government spending

This is due to the non-income determinants making autonomous expenditures higher or lower to begin with

Question 30

Recessionary Output Gap

Answer 30

When equilibrium aggregate expenditure is below the level needed for full employment

Question 31

Inflationary Output Gap

Answer 31

When equilibrium aggregate expenditure exceeds the level needed for full employment

Question 32

Multiplier effect

Answer 32

Keynesian economics asserts that a change in autonomous expenditure can have a ripple effect on the rest of expenditure (when spending by one person in an economy causes increases in spending of other people that is greater than the initial increase in expenditure)

Question 33

What is the end result of the multiplier effect on PAE

Answer 33

When the multiplier process comes to an end, the economy reaches a Keynesian equilibrium where unplanned aggregate expenditure is equal to zero, or alternatively when planned aggregate expenditures are equal to zero

Question 34

How do you calculate the multiplier effect?

Answer 34

Final change in output for an increase in expenditure of $100 is equal to:
ΔY = $100 × (1/ 1− b)

For example, if b is equal to 0.8, then the final change in expenditure would be:

1/(1-0.8) = 5.

So the final change in aggregate expenditure would be five times higher than the initial change in aggregate expenditure