Test #3 (chapter 11) Flashcards
Households and firms are _____________. Booms and busts involve chain reactions
interdependent
What are the four assumptions in using the multiplier?
- Producers are willing to supply additional output at a fixed price
- interest rate is given
- no government spending and no taxes (GDP = disposable income)
- exports and imports are zero
What is the MPC?
Marginal propensity to consume
- how much consumers spend when they receive more income
MPC = change in consumer spending / change in disposable income
What is the MPS?
Marginal propensity to save
- when we receive more income, whatever is not spent, is saved
MPS = 1 - MPC
What is the multiplier formula?
How can you use the multiplier formula to calculate the change in real GDP (triangleY)
multiplier : 1 / 1 - MPC
triangleY (change in real GDP) = (1 / 1 - MPC) x triangleAE0 (autonomous change in aggregate spending)
**so multiplier also = triangleY / triangleAE0
In what way does the multiplier depend on MPC?
If MPC is high, so is the multiplier (higher MPC = less disposable income leaking into savings at each round of expansion)
What is the individual consumption function?
What is the aggregate consumption function?
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
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?
y axis = c (household consumer spending)
x = yd (household current disposable income)
y-intercept = ac (autonomous consumer spending)
slope = MPC
taken from the individual consumption function, when yd goes up by $1, c goes up by _____
MPC x $1
What causes shifts in the consumption function?
(there’s a hypothesis for each point)
- 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) - 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
investment spending is ____ compared to government spending and consumption spending
what’s a big characteristic of investment spending?
low
it’s very volatile and can change a lot during changes in the business cycle (tends to drive business cycles)
What is planned investment spending and what does it depend on?
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
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
lower
higher
What are RGDP expectations?
a proxy (value) of future sales
What is the accelerator principle?
higher growth rate in RGDP = higher level of planned investment spending
lower growth rate in RGDP = lower planned investment spending (+ accelerating recession)
What is actual investment spending?
actual investment spending (I) = Iunplanned + Iplanned
What is Iunplanned (unplanned investment spending)
Iunplanned = unplanned inventory investment - the unintended swing in inventory that occurs when actual sales are higher or lower than expected sales
What are inventories? What do decreases and increases signify?
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
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)
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)
In the Income-Expenditure model, what is AEplanned?
At equilibrium, AEplanned = _______
it is planned aggregate expenditure : the total amount of planned spending in the economy
AEplanned = C + Iplanned
at equilibrium = GDP (bc Iunplanned = 0?)
At equilibrium in the Income-Expenditure model, what is Iunplanned?
= 0
(firm made no mistakes + guessed everything right)
Planned aggregate spending can be different from real GDP when __________ is not zero
explain…
Iunplanned
When Iunplanned is positive, RGDP exceeds AEplanned
When Iunplanned is negative, RGDP is less than AEplanned
What are the 2 sources of a shift in the planned aggregate spending line? (income-expenditure model)
- change in planned investment spending (ex. change in interest rate)
- shift of the aggregate consumption function (ex. change in wealth) (ex. increase in the autonomous consumption spending - y-intercept)
What is the paradox of thrift in relation to the multiplier effect (on the income-expenditure graph)?
if consumers or producers increase spending, the increase in equilibrium GDP is several times larger than the original increase
Explain the effect of international trade on the income-expenditure model.
What does it mean by economic interdependence?
- 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
What is an autonomous change in aggregate expenditure?
= 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
define the multiplier
the ratio of total change in real GDP caused by an autonomous change in aggregate expenditure to the size of that autonomous change
most recessions originate as a fall in __________
investment spending
What is one case where we can be reasonably sure that firms will undertake high levels of investment spending
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
