National income and price determination Part 2

Question 1

The slope of the ______ function equals the MPS (Marginal Propensity to Save).

Answer 1

savings

Explanation

The slope of any “curve” can be measured by the ratio of the vertical change to the horizontal change when moving from one point on the curve to another. The savings function plots savings and disposable income therefore the slope would be the change in Saving divided by the change in disposable income which equals the MPS.

Question 2

Disposable income equals real ____ minus net taxes.

Answer 2

GDP

Explanation

Net taxes are taxes paid to the government minus transfers received from the government. Net taxes are determined by the marginal tax rate.

Question 3

As real GDP increases, disposable income increases, but by less than the increase in real GDP because _________ also increase.

Answer 3

net taxes

Explanation

The effect of taxes is to take a higher portion of your income as your income increases. Disposable income then is reduced more than the accompanying change in real GDP.

Question 4

The effect of an ________ in real GDP on consumption expenditure is determined by the marginal propensity to consume out of real GDP.

Answer 4

increase

Explanation

Consumer spending is what drives changes in the aggregate demand curve and as spending increases, the GDP increases as well.

Question 5

The marginal propensity to consume out of ________ equals the MPC multiplied by 1 minus the marginal tax rate.

Answer 5

real GDP

Explanation

For example, if the marginal propensity to consume is 0.75, and the marginal tax rate is 0.2, then the marginal propensity to consume out of real GDP is 0.75 x (1 - 0.2) = 0.6. The MPC equals 0.75 but the resulting MPC out of Real GDP is a smaller 0.6.

Question 6

Investment equals spending for the production and accumulation of _______ goods and additions to inventory.

Answer 6

capital

Explanation

Investment in an economic sense includes such things as the purchase of new buildings, equipment, and inventories by businesses. (It also includes the purchase of new houses and apartments).

Question 7

Changes in real GDP do not change __________ plans.

Answer 7

investment

Explanation

The main influences on investment are the expected rate of profit (how much extra money will be available for investment) and the real interest rate (how expensive will the cost of borrowing money be). Both of these influences on investment are independent of real GDP.

Question 8

Changes in real GDP do not change government ____________.

Answer 8

expenditures

Explanation

Government expenditures are the purchases of goods and services by governments. These expenditures are determined by the political process, and are independent of real GDP.

Question 9

_______ are the purchases of domestic goods and services by foreigners.

Answer 9

Exports

Question 10

Changes in domestic real GDP do not change ________ exports.

Answer 10

domestic

Explanation

Exports depend on: international prices, international trade agreements, and real GDP in the rest of the world. They are not based on domestic purchasing.

Question 11

______ are the purchases of foreign goods and services.

Answer 11

Imports

Explanation

Import spending includes spending by individuals, firms, and governments of an economy for goods and services produced in foreign nations.

Question 12

All other things being the same, an ________ in real GDP increases imports.

Answer 12

increase

Explanation

The marginal propensity to import is calculated as the change in imports divided by the change in real GDP and is shown by the slope of the import function.
For example, going from point b to point d:

Change in imports = 50 billion
Change in Real GDP = 200 billion
Marginal Propensity to Import, or the Slope, equals = 0.25.

Question 13

The aggregate ___________ schedule lists the level of aggregate planned expenditure at each level of real GDP.

Answer 13

expenditure

Explanation

The following table is an aggregate expenditure schedule where Y = C + I + G + X - M(imports):

1) An important thing to note is – changing the GDP does not have any effect on Investment, Government expenditures, and exports. Those numbers stayed the same, while consumption expenditure increased.

Question 14

The Aggregate Expenditure (AE) curve is made up of from the ___________ function minus the import function plus I, G, and X.

Answer 14

consumption

Explanation

Aggregate Expenditure (AE) is the expenditure that is planned. Actual aggregate expenditure is always equal to real GDP but Aggregate planned expenditure can differ from real GDP because of unplanned changes in inventories.

Question 15

Autonomous expenditure is that part of aggregate planned expenditure that does not change when ________ changes.

Answer 15

real GDP

Explanation

These are the fixed costs that society has regardless of production level (rent, heat, etc).

Question 16

_______ expenditure is that part of aggregate planned expenditure that does change when real GDP changes.

Answer 16

Induced

Explanation

These are the variable costs that increase and decrease as production increases (labor, material, utilities).

Question 17

________ expenditure is the level of aggregate expenditure when aggregate planned expenditure equals real GDP.

Answer 17

Equilibrium

Explanation

The AE curve shows aggregate planned expenditure at each level of real GDP. The 45 degree line shows actual aggregate expenditure at each level of real GDP. Only at point “d” is actual aggregate expenditure equal to aggregate planned expenditure. So, $600 billion is equilibrium real GDP.

Question 18

At Equilibrium Expenditure, aggregate planned expenditure equals real GDP, so ___________ remain at their target levels.

Answer 18

inventories

Explanation

Below $600 billion, aggregate planned expenditure exceeds real GDP, so inventories fall below their target levels and firms increase production. Above $600 billion, aggregate planned expenditure is less than real GDP, so inventories rise above their target levels and Firms decrease production. At Equilibrium Expenditure firms do not change production.

Question 19

The multiplier is the amount by which a change in aggregate expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.

Answer 19

multiper

Explanation

A change in expenditure generates a change in income, this change in income induces a change in consumption expenditure and this increase in consumption expenditure increases income further and so on… and so on… Any change in income will cause both consumption (MPC) and saving (MPS) to vary as a fraction of that change in income.

1) In the original situation (AE0), equilibrium is 600 billion, the level at which aggregate planned expenditure equals real GDP. Now suppose that aggregate planned expenditure increases by 100 (AE1) to 700 billion.
The equilibrium expenditure has now increased by 150 to 750 billion, but aggregate planned expenditure increased by only 100. The additional 50 billion is induced expenditure and results from the multiplier.

Question 20

The multiplier equals a change in ________ expenditure divided by a change in aggregate expenditure.

Answer 20

equilibrium

Explanation

Change in Y Change in AE

(750 - 600 ) (700 - 600)

150 100

Multiplier = 1.5

Question 21

The size of the Marginal Propensity to Save (MPS) and the __________ are inversely related.

Answer 21

multiplier

Explanation

The smaller the fraction of any changes in income that is saved, the greater the re-spending will be and thus the greater the multiplier. The multiplier, then, is equal to the reciprocal of the MPS: 1 / MPS
And since we know that MPC + MPS = 1 or MPS = 1 - MPC we can also conclude that Multiplier = 1 (1 - MPC).

Question 22

The higher the marginal propensity to _______ (the lower the marginal propensity to save), the larger is the multiplier.

Answer 22

consume

Explanation

Multiplier = 1 (1 - MPC)
A larger MPC equals a smaller denominator and thus a larger multiplier.
Anything that causes the MPC to increase will cause the multiplier to increase.
If MPC = .75 then the multiplier = 4
If MPC = .9 then the multiplier = 10
Likewise, If MPS = 0.2 (MPC = 1.0 - 0.2 = 0.8) then the multiplier = 1 / 0.2 = 5

Question 23

If the MPC = 0.__, the multiplier is 2.86.

Answer 23

.65

Explanation

MPC = 0.65 
Multiplier = 1 / (1-0.65) = 1 / 0.35 = 2.86

Question 24

The magnitude of the multiplier depends on the slope of the AE (_________ expenditure) curve

Answer 24

aggregate

Explanation

The steeper the AE curve, the greater the MPC and the larger is the multiplier.

Question 25

The Classical Theory of Employment concludes that the ____________ economy would tend to employ its resources fully.

Answer 25

capitalistic

Explanation

This theory argues that under spending is unlikely to occur. If a deficiency in spending did occur, price-wages would be adjusted accordingly so that decreased spending would not result in decreased output, employment, or real income. The four basic assumptions of the Classical model are:

• Pure competition exists - No single buyer or seller can control the prices of a commodity or input
• Wages and prices are flexible - All prices for inputs and outputs are free to adjust according to demand and supply
• People are motivated by self-interest - Businesses want to maximize profit, and individuals want to maximize their utility.
• People cannot be fooled by money illusion - Buyers and sellers know that simply doubling all prices and incomes will not mean a change in real standards of living.

Question 26

“Supply creates its own demand” is known as ___’s Law.

Answer 26

Say

Explanation

The very act of producing goods generates an amount of income exactly equal to the value of the goods purchased. Say’s Law is at the root of Classical economic theory.

Question 27

______ is a type of leakage in the circular flow of income and output.

Answer 27

Saving

Explanation

Since people engage in savings, then there won’t be as much demand as there is income in the economy, and hence noequilibrium. The classical economists believed this “problem” would be taken care of through a change in interest rates. As saving increased, this would lower interest rates, and thereby encourage investment. This investment by firms would result in an increase in demand that offset the loss due to saving. The market for saving and investment would equalize as shown in the above graph.

Question 28

Under Classical theory wages would adjust to ensure that there would be no excess ____________.

Answer 28

unemployment

Explanation

In the Classical view of the world, all unemployment is “voluntary”. If you can’t find a job, you simply need to lower your wage demands. There would be no unions or minimum wages as they would only keep unemployment artificially high.

Question 29

In the Classical Theory of Employment, the Long-Run Aggregate Supply (LRAS) curve is ________.

Answer 29

vertical

Explanation

Because the classical assumptions assumed that all prices, wages and interest rates were flexible, there would never occur any situation in which full employment was not reached. Long-term unemployment is impossible. In the Aggregate Demand - Aggregate Supply model, this production is represented as a vertical curve. In the classical model this is the only aggregate supply curve possible. Deviations from this curve are only very temporary.

Question 30

In the classical theory, an increase in aggregate demand will cause a change in the price level, but no change in the ______ level.

Answer 30

output

Explanation

Any attempt to move to a higher level of production will cause prices to rise (E1 to E2). Input costs will be bid up in proportion to the price level changes resulting in the move from Q1 back to Q0. Because the level of real GDP does not change with changes in AD, the model is one which is supply determined.

Question 31

The economic model that asserts that a Capitalist economy does not tend to employ its resources fully is called _________ Economics.

Answer 31

Keynesian

Explanation

In the Keynesian model, there are some key assumptions that are quite different from those made in the classical mode. First, prices (and wages) are not flexible. The prices are “sticky downward” because of the existence of long term contracts and there is considerable resistance to lowering prices and wages. The existence of union contracts, and long-term contracts for raw materials is the source of this inflexibility. Thus, Keynes argued that it was possible to have large amounts of unemployment and excess capacity. Capitalism was not necessarily completely self-regulating.

Question 32

Under Keynesian economics, the Short-Run Aggregate Supply (SRAS) curve will be __________.

Answer 32

horizontal

Explanation

With Keynesian assumptions in place the Short-run aggregate supply curve will be horizontal, and the economy is demanddriven. The Keynesian model of economics is the model that most economic theory is based on.

Question 33

_____ policy is the government’s attempt to influence the economy by setting and changing taxes, transfer payments, and expenditures on goods and services.

Answer 33

Fiscal

Explanation

The government can control the economy through its budgets. The closer that we stay to the potential output of the economy (shown as the GDP trend) the less the costs of unemployment and inflation.

• Driving the economy is more like trying to control an elephant, it isn’t very predictable and the controls don’t seem to always work. The economy’s business cycle is unpredictable, and so the government sometimes has a hard time figuring out which way to go.
• The objective of the government is to get the economy to a low, non-inflationary rate of unemployment. The demand side effects of fiscal policy are similar regardless of whether taxes or government spending are changed.

Question 34

The period of time that allows producers to change the quantity of some, but not all, of the resources they employ is called _______.

Answer 34

Short-run

Explanation

Some resources are fixed (stay the same regardless of production levels i.e. rent) and some are variable (change with production levels i.e. labor). The short run is not long enough for firms to change their plans and adjust their fixed costs according to new production levels. In other words, in the short run, only variable costs change. In the long run, there are no fixed or variable costs – everything is essentially variable.

Question 35

The ________ is a period of time long enough to enable producers to change the quantities of all the resources they employ.

Answer 35

long-run

Explanation

All costs are considered variable as they have time to adjust to an increase or decrease in production.

Question 36

An ____________ fiscal policy is an increase in government expenditures or a decrease in taxes.

Answer 36

expansionary

Explanation

Expansionary fiscal policy entails increased government spending or lower taxes or a combination of the two. It serves to expand (increase) economic spending. A $100 billion increase in government expenditures shifts the AE curve upward by $100 billion. Here, the multiplier is 1.5, so equilibrium expenditure increases by $150 billion.

Question 37

____________ fiscal policy is used to counteract a recession.

Answer 37

Expansionary

Explanation

The government uses discretionary fiscal policy to create an economic environment more conducive to business growth and increased productivity. Increased government spending increases demand for labor and materials and tax cuts motivate business to invest and workers to buy more with their increased discretionary income. Unfortunately, the increased spending results in a deficit budget.

Question 38

A _____________ fiscal policy is a decrease in government expenditures or an increase in taxes.

Answer 38

contractionary

Explanation

Contractionary fiscal policy decreases government spending or increases taxes or a combination of both. It serves to contract (decrease) economic spending.

Question 39

Contractionary ______ policy is used to counteract inflation.

Answer 39

fiscal

Explanation

To control prices and productivity the government will decrease spending or increase taxes. These measures hope to stop the rise of demand and subsequent prices giving the economy a chance to increase GDP and bring the equilibrium expenditure back in line.

Question 40

Appropriate changes in government expenditures that occur _________ are called automatic stabilizers.

Answer 40

naturally

Explanation

These are the changes in taxes and government spending that automatically occur as the state of the economy changes. Taxes fall and outlays rise in a recession; taxes rise and outlays fall in an expansion. Because taxes and outlays fluctuate with the state of the economy, so does the deficit.

Question 41

In a ___________ tax system the average tax rate (tax revenue / GDP) rises with GDP.

Answer 41

progressive

Explanation

Government determines tax rates and so the amount of tax paid will vary with GDP. As GDP rises so does the tax revenue, creating a contractionary budget surplus. Conversely, as GDP falls, tax revenue declines and this causes an expansionarybudget deficit thereby cushioning the economic contraction. A progressive tax rate creates more built in economic stability.

Question 42

A ________ deficit is one that arises out of a recession.

Answer 42

cyclical

Explanation

This deficit results as a by-product of the fiscal inaction that allowed the economy to slide into a recession. This is subject to the rises and falls of the business cycle.

Question 43

A ________ deficit persists even at full employment.

Answer 43

structural

Explanation

This indicates that the economy has a fundamental flaw– there are not enough resources to meet aggregate demand and thus the government must continue to intervene to keep prices under control. This is a “natural” deficit.

Question 44

Fiscal Policy changes that increase (decrease) equilibrium expenditure will increase (decrease) Aggregate ______.

Answer 44

Demand

Explanation

The AD curve shifts rightward by the amount determined by the multiplier. In the short run this will increase (decrease) GDP and AD. In the example Real GDP increases to $700 and the price level rises to 140. If potential GDP is equal to $700 billion, this outcome is also the long-run outcome.

Question 45

When a fiscal expansion occurs at _________ GDP the Short-Run Aggregate Supply curve (SAS) shifts left.

Answer 45

Potential

Explanation

A fiscal expansion means increased aggregate demand. As you can see in the graph, that results in the SAS curve shifting to the left.

This happens because real GDP exceeds potential GDP and then there is a shortage of labor. This causes the real money wage rate to increase, the price level rises further, and real GDP decreases back toward potential GDP.
Fiscal expansion at potential GDP that does not induce an increase in Aggregate Supply will leave real GDP unchanged after a temporary increase. The real GDP is forced back to original levels because the economy has undergone no change (improved technology, more resource) that will serve to increase the economic potential.

Question 46

An increase in government expenditure that is productive and can ________ aggregate supply will shift the SAS curve right.

Answer 46

increase

Explanation

Increasing government expenditure on highways, airports or dams (capital stock) will increase Aggregate Supply and potential GDP. A decrease in taxes can be productive and can increase aggregate supply. Some examples include – a cut in the income tax increases the supply of labor, and a cut in capital taxes increases investment and saving.

Question 47

The ___________ view of fiscal policy is that the demand side effects are large and the supply side effects small.

Answer 47

traditional

Explanation

Real GDP increases and the price level rises.
Potential GDP increases, but by a small amount.

Question 48

An alternative “Supply-Sider” view is that the supply side effects are the ________ ones.

Answer 48

dominant

Explanation

A fiscal policy that cuts tax rates will increase disposable income and thus increase household saving. These cuts will also increase the profitability of businesses and increase the rate of investment.

Productive capacity will grow and Real GDP increases and the price level falls. Further, the lower tax rates will induce more people to enter the work force and supply grows some more. Supply-Siders also contend that lower tax rates will ultimately increase tax revenue due to the expansion of the tax base.

Question 49

The argument that an expansionary fiscal policy will increase interest rates and reduce investment spending is called the _________ Out Effect.

Answer 49

Crowding

Explanation

When the government increases spending in an effort to expand the economy, it must borrow those funds. This in itself increases the demand for loanable funds and the interest rates go up. Because investment varies with the interest rate, some investment spending will, therefore, be “choked-out.” This decreased investment may render the fiscal policy initiative completely ineffective.

Question 50

The Ricardian ___________ Theorem suggests an increase in public debt will have little or no effect on real output or employment because people will choose to save more money.

Answer 50

Equivalence

Explanation

David Ricardo suggested many years ago that taxpayers would not be “fooled” by the government borrowing today, but would react to an increase in government debt by changing their behavior today. The belief is that they will anticipate thattaxes will rise in the future to pay for the debt incurred today and, in the extreme case, government spending would therefore have no effect on AD (Aggregate Demand) at all!