Test #3 (chapter 11)

Question 1

Households and firms are _____________. Booms and busts involve chain reactions

Answer 1

interdependent

Question 2

What are the four assumptions in using the multiplier?

Answer 2

1. Producers are willing to supply additional output at a fixed price
2. interest rate is given
3. no government spending and no taxes (GDP = disposable income)
4. exports and imports are zero

Question 3

What is the MPC?

Answer 3

Marginal propensity to consume
- how much consumers spend when they receive more income

MPC = change in consumer spending / change in disposable income

Question 4

What is the MPS?

Answer 4

Marginal propensity to save
- when we receive more income, whatever is not spent, is saved

MPS = 1 - MPC

Question 5

What is the multiplier formula?
How can you use the multiplier formula to calculate the change in real GDP (triangleY)

Answer 5

multiplier : 1 / 1 - MPC

triangleY (change in real GDP) = (1 / 1 - MPC) x triangleAE0 (autonomous change in aggregate spending)

**so multiplier also = triangleY / triangleAE0

Question 6

In what way does the multiplier depend on MPC?

Answer 6

If MPC is high, so is the multiplier (higher MPC = less disposable income leaking into savings at each round of expansion)

Question 7

What is the individual consumption function?
What is the aggregate consumption function?

Answer 7

Equation showing how an individual household’s consumer spending varies with the household’s current disposable income :
c = a + MPC x yd

c = a household’s consumer spending
yd = household disposable income
MPC = marginal propensity to consumer
a = autonomous consumer spending –> what a family would spend even with zero income (assume it’s greater than zero because a household has to have some savings to fund necessary consumption)

AGGREGATE consumption function:
- the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending
C = AC + MPC x YD

Question 7

On the graph representation of the individual consumption function, what is on the y and x axis
what is the y-intercept?
what is the slope?

Answer 7

y axis = c (household consumer spending)
x = yd (household current disposable income)

y-intercept = ac (autonomous consumer spending)
slope = MPC

Question 8

taken from the individual consumption function, when yd goes up by $1, c goes up by _____

Answer 8

MPC x $1

Question 9

What causes shifts in the consumption function?
(there’s a hypothesis for each point)

Answer 9

1. changes in expected future disposable income
   -> permanent income hypothesis: consumption depends on expected income over the long term
   *people with high current income save a larger fraction of their income than those with low current income –> there is a positive relationship between current income and the savings rate
   (Higher current income tends to lead to higher savings today, but higher expected future income tends to lead to less savings today)
2. changes in aggregate wealth
   -> life-cycle hypothesis : consumers plan their spending over a lifetime
   (consumption smoothing - ppl try to smooth their consumption over their lifetimes)

ex.
you expect to get a better job = upward shift
stock market crashes = downward shift

Question 10

investment spending is ____ compared to government spending and consumption spending
what’s a big characteristic of investment spending?

Answer 10

low

it’s very volatile and can change a lot during changes in the business cycle (tends to drive business cycles)

Question 11

What is planned investment spending and what does it depend on?

Answer 11

planned investment spending = the investment spending that businesses intend to undertake during a given period

depends on:
1. interest rate (lower interest rate = higher investment spending)
2. expected future real GDP
3. current level of production capacity

Question 12

For a given level of expected future RGDP, the HIGHER the current capacity, the _______ is the investment spending

For a given level of current capacity, the higher the future expected RGDP, the ________ is the investment spending

Answer 12

lower

higher

Question 13

What are RGDP expectations?

Answer 13

a proxy (value) of future sales

Question 14

What is the accelerator principle?

Answer 14

higher growth rate in RGDP = higher level of planned investment spending

lower growth rate in RGDP = lower planned investment spending (+ accelerating recession)

Question 15

What is actual investment spending?

Answer 15

actual investment spending (I) = Iunplanned + Iplanned

Question 16

What is Iunplanned (unplanned investment spending)

Answer 16

Iunplanned = unplanned inventory investment - the unintended swing in inventory that occurs when actual sales are higher or lower than expected sales

Question 17

What are inventories? What do decreases and increases signify?

Answer 17

Inventories = stocks of goods and raw materials held to satisfy future sales
- if firms produced too much, Iunplanned will be positive
- if firms produced too little, Iunplanned will be negative

Decrease = sign of future expansion
Increase = sign of future contraction

Question 18

Within the Income-Expenditure model, What are the equations for GDP?
What’s one other thing we assume in addition to all of the assumptions for the multiplier)

Answer 18

GDP = C + I (aka total spending)
aka… GDP = C + Iplanned + Iunplanned
aka… GDP = AEplanned + Iunplanned

YD = GDP (aka disposable income)

*we’re working with the aggregate consumption function (C = A + MPC x YD)

assume Iplanned is fixed (bc interest rate is fixed)

Question 19

In the Income-Expenditure model, what is AEplanned?
At equilibrium, AEplanned = _______

Answer 19

it is planned aggregate expenditure : the total amount of planned spending in the economy
AEplanned = C + Iplanned

at equilibrium = GDP (bc Iunplanned = 0?)

Question 20

At equilibrium in the Income-Expenditure model, what is Iunplanned?

Answer 20

= 0
(firm made no mistakes + guessed everything right)

Question 21

Planned aggregate spending can be different from real GDP when __________ is not zero
explain…

Answer 21

Iunplanned

When Iunplanned is positive, RGDP exceeds AEplanned

When Iunplanned is negative, RGDP is less than AEplanned

Question 22

What are the 2 sources of a shift in the planned aggregate spending line? (income-expenditure model)

Answer 22

1. change in planned investment spending (ex. change in interest rate)
2. shift of the aggregate consumption function (ex. change in wealth) (ex. increase in the autonomous consumption spending - y-intercept)

Question 23

What is the paradox of thrift in relation to the multiplier effect (on the income-expenditure graph)?

Answer 23

if consumers or producers increase spending, the increase in equilibrium GDP is several times larger than the original increase

Question 24

Explain the effect of international trade on the income-expenditure model.
What does it mean by economic interdependence?

Answer 24

• exports are like an increase in autonomous spending (shift of curve)
• the multiplier process is weaker with foreign trade –> imports are a leakage from the economy (shift upwards will be less than if there was no import)
  (marginal propensity to import - tells us what percent of the new spending is spent on imports)
• economic interdependence : lower exports affect trade partners and many countries tend to have recessions and recoveries at the same time

Question 25

What is an autonomous change in aggregate expenditure?

Answer 25

= AE0

• an initial rise of fall in aggregate expenditure at a given level of RGDP
• self-governing because it’s the cause of the chain reaction

Question 26

define the multiplier

Answer 26

the ratio of total change in real GDP caused by an autonomous change in aggregate expenditure to the size of that autonomous change

Question 27

most recessions originate as a fall in __________

Answer 27

investment spending

Question 28

What is one case where we can be reasonably sure that firms will undertake high levels of investment spending

Answer 28

when they expect sales to grow rapidly
- In this case, even excess production capacity will soon be used up, leading firms to resume investment spending