Macroeconomics: chapter 8

What are the most important factors that influence the consumption and saving decisions in the economy?

1. disposable income 2. interest rates 3. expected future income 4. net wealth

Suppose that the Marginal Propensity to Consume (MPC) in an economy is 0.6 and the government has just passed an $800 billion stimulus package. According to the multiplier effect, by how much will the government stimulus increase Real GDP?

Change in RGDP = change in government spending x multiplier Multiplier = 1/MPS = 1/0.4 = 2.5 Change in RGDP = $800 billion x 2.5 = $2 trillion increase

Why is the value of the multiplier greater than one?

Change in RGDP > Change in spending This is due to the fact that RGDP depends on Consumption (RGDP = C + I + G + NX) and Consumption depends on RGDP [C = c0 + c1(Y-T)]. If spending in the economy increases, RGDP increases as businesses produce more. The new spending becomes new income, so consumption in the economy rises. As consumption begins to rise, RGDP rises again due to the higher demand for goods and services. This process occurs until there is no more new spending added to the economy.

If households in the economy decide to save a larger portion of any extra income that they earn (an increase in the MPS), then the multiplier effect from an increase in spending will:

Decrease

Briefly explain the "Paradox of Thrift".

During an economic recession, cutting spending and increasing saving is a logical response for an individual, but is harmful for the entire economy. This is because your spending is someone else's income. If everyone cuts spending in response to a recession, then average income in the economy falls, making the economy way worse.

When Disposable Income in the economy is $10.5 trillion, the level of consumption is $9 trillion. When Disposable Income in the economy is $11 trillion, the level of saving is $1.65 trillion. Calculate the Marginal Propensity to consume. What was the Marginal Propensity to Save?

MPC = (change in Consumption)/(change in Disposable income) MPC = (9.35-9)/(11-10.5) = 0.7 MPC + MPS = 1, so MPS = 0.3

When the level of Investment in the economy is $2 trillion, Real GDP is $12 trillion. When investment spending increases to $2.5 trillion, the level of Real GDP increases to $13 trillion. What is the value of the multiplier in this economy?

Multiplier = (change in GDP)/(change in spending) Multiplier = $1T/$0.5T = 2, GDP increase $2 for every $1 increase in Investment spending

What happens to the level of National Saving if the government runs a budget surplus?

National Saving = Private saving + public saving A budget surplus will increase national saving. A budget deficit will reduce national saving

A firm invests in a new machine that costs $4,000 a year but which is expected to produce an increase in total revenue of $4,240 a year. The current real rate of interest is 7 percent. The firm should:

Not undertake the investment because the expected rate of return of 6 percent is less than the real rate of interest.

What are the three sources of Investment funds in the economy?

Private savings - majority of funds from this source Public savings - gov. budget surplus Borrowing from foreign financial markets

The multiplier effect occurs when spending in the economy increases because of the relationship between which two variables?

Real GDP and Consumption

What factors influence the level of Investment Demand?

Real interest rate & expected rate of return

Briefly explain the crowding-out effect. How does the crowding-out effect affect the long-run growth potential of the economy?

When the government runs a budget deficit they must borrow to make up the short-fall in the budget. The government borrows money from the same sources as private businesses (private savings). When the government consumes some of the private savings to finance the deficit, this leaves less money available in the financial system for businesses to borrow. The lower availability of funds drives up the price of borrowing (interest rates) and reduces the level of private investments. A lower investment level will reduce the long-run growth rate of an economy do to a slower pace of capital formation.

What happens to the size of the multiplier as the Marginal Propensity to Consume (MPC) increases in the economy?

a higher MPC yields a larger multiplier due to the extra money going back into the economy as new spending

What happens to the size of the multiplier if the level of taxes or the level of imports increases?

an increase in taxes or spending on imports will reduce the size of the multiplier

how will an increase of interest rates influence consumption and savings?

an increase will cause consumption and saving to increase

how will and increase of disposable income influence consumption san savings?

an increase will cause consumption and saving to increase

how will an increase of expected future income influence consumption and savings?

an increase will increase consumption and a decrease saving

how will an increase of net wealth influence consumption and savings?

an increase will increase consumption and decrease saving

What happens to the level of investment when real interest rates are reduced?

rates lowers the cost of borrowing money and will increase Investment.

What happens if the government runs a budget deficit?

reduce national saving

What happens to the level of investment when expected rate of return is reduced?

represents a less profitable investment project, lower profits will tend to reduce investment