Unit 14

Question 1

This unit is about

Answer 1

The multiplier model

• how large would the total direct and indirect impact of a rise in investment spending or governments spend

Question 2

Aggregate consumption =

Answer 2

Autonomous consumption + consumption which depends on income

C = c0 +Yc1

Question 3

Slope of the consumption function

Answer 3

• how much of added income will be used for consumption spending, i.e the marginal propensity to consumer

Question 4

Flaw of the AC model without government and foreign trade

Answer 4

• even when income is 0, autonomous consumption somehow above 0

Question 5

Now add in investment into the AC model

Answer 5

AD = c0 + Yc1 + I

Y intercept is no c0 + I

Question 6

Positive AD shock impact on AD I model incomes

Answer 6

Increase in AD, vertically shown, so horizontal translation to 45o line of increase in income to match output at that point, continues until new AD curve meets the 45o diagram.

• smaller and smaller subsequent jumps in AD + income due to MPC

Question 7

Important assumption on capacity utilisation + wages in AC I ad shift

Answer 7

firms can only increase output if capacity not met, also we assuming short run, so instead of increasing wages, they are hiring more wages.

Question 8

Equilibrium in this model is at

Answer 8

When AD meets the 45o line

Question 9

Negative AD shift - fall in I

Answer 9

So investment falls, so y intercept falls, so AD shifts down by exactly 1.5 billion, and thus firms will reduce output by 1.5 billion, to reach point C from B. Then, now incomes have fallen by 1,5 billion on the x axis, given the MPC - c1, consumption will also fall, so move from C to D, lower demand so lower output, etc all the way to point Z.

Question 10

Multiplier in this simplified model

Answer 10

Y = (1/1-c1)(c0+I’)

Multiplier is 1/1-c1 = 1/1-MPC

Question 11

Financial accelerator

Answer 11

change in value of collateral like houses or cars means ability/ amount borrowed will change.

Question 12

Firm can spend their money on:

Answer 12

• dividends
• Savings
• Investment abroad
• Investment at home

Question 13

Desirability of consumer to consumer now rather than later depends on

Answer 13

Discount rate, p

Question 14

Relationship between p,r, profit rate and firm decisions

Answer 14

• if p is greater than r and profit rate, owners keep funds and increase consumption spending
• If r is greater than p and profit rate: the decision will be to repay debt or purchase a financial asset.
• If profit rate is greater than p and r: the owner will invest

Question 15

Full multiplier model

Answer 15

AD = c0 + c1(1-t)Y + I + G + X -mY

1-t is taxation effect on net income
M is MPI.

Question 16

Multiplier on full AD model

Answer 16

Y = (c0 + I + G + X)/(1-c1(1-t) + m)

Multiplier is (1-c1(1-t) + m)

Question 17

3 main ways government spending and taxation can dampen fluctuation in the economy

Answer 17

• The size of government
• Government provides unemployment benefits
• Government can intervene via fiscal policy

Question 18

Paradox of thrift

Answer 18

Shock to economy - save more, but if everyone does that, an aggregate attempt to increase in savings leads to a fall in aggregate income.

The paradox lies in the fact that what may be individually rational behavior can have bad effects on economy.

Question 19

Fallacy of composition

Answer 19

Paradox of thrift is an illustration of this as when individuals make decisions based on their own circumstances, assuming what’s rational for them is optimal for society.

Question 20

Private sector dampening mechanism

Answer 20

Consumption smoothing

Question 21

Private sector amplifying mechanisms

Answer 21

credit constraints limiting consumption smoothing, rising value of collateral, rising capacity utilisation in a boom.

Question 22

Gov dampening mechanisms

Answer 22

automatic stabilisers, stabilisation policy

Question 23

Gov amplifying mechanisms

Answer 23

Policy mistakes

Question 24

Crowding out

Answer 24

Can also occur

Question 25

Labour market and AD

Answer 25

Labour market equilibrium is at demand model equilibrum, but a demand model equilibrum will not translate always to a labour market equilibrum as it is a short run model.