ECO
A reduction in the real interest rate will increase investment spending, other things equal, because firms will make an investment purchase if the expected return is
greater than or equal to the real interest rate at which it can borrow. EXPLANATION: Firms will only make an investment purchase if the expected return is greater than or equal to the real interest rate at which it can borrow. The logic is as follows. If you borrow $100 at an interest rate of 10 percent, then at the end of the year you will owe $110. Now, if you can earn a rate of return of 20 percent on the borrowed $100, then you will have $120 from your investment at the end of the year. You pay off the $110 loan and keep $10. This is a good investment. However, if you earn a rate of return of 5 percent on the borrowed $100, then you will have $105 from your investment at the end of the year. You pay off the $110 loan and lose $5. This is a bad investment. Using this logic, a reduction in the real interest rate will make previously unprofitable investments profitable. Thus, other things equal, this will increase investment. For example, if the real interest rate fell from 10 percent to 3 percent it would be a good investment to borrow at 5 percent now, where it wasn't before when the real interest rate was 10 percent.
The multiplier is
larger, the larger the MPC is and the smaller the MPS is. EXPLANATION: To answer this question, we use the following relationships. MPC + MPS = 1 Multiplier = 1/(1 − MPC) Multiplier = 1/MPSFrom above, we see that an increase in the MPC increases the multiplier and a decrease in the MPC decreases the multiplier. For the MPS, we see that an increase in the MPS decreases the multiplier and a decrease in the MPS increases the multiplier.
In year one, Adam earns $1,000 and saves $100. In year 2, Adam gets a $500 raise so that he earns a total of $1,500. Out of that $1,500, he saves $200. What is Adam's MPC out of his $500 raise?
0.80 EXPLANATION: Adam's MPC out of his $500 raise is 0.80. That is true because when Adam's income goes up by a marginal (extra) $500, his consumption goes up by a marginal (extra) $400. Those numbers allow us to calculate the MPC as: MPC=change in consumptionchange in incomeMPC = change in consumptionchange in income Substituting Adam's values into the formula tells us that MPC = 0.80 (= $400/$500). If you are confused about Adam's marginal consumption going up by exactly $400, think about how much he was consuming in each year. To do so, remember that any money that is not saved is by definition consumed. So when Adam saves $100 in year 1 out of an income of $1,000, he must be consuming $900 (= $1,000 - $100) that year. In the same way, when he is saving $200 out of an income of $1,500 in year 2, he must be consuming $1,300 (= $1,500 - $200). Looking at those two consumption numbers, we see that Adam's consumption rises from $900 in year 1 to $1,300 in year 2, which is a $400 increase. And because that $400 increase came in response to a $500 increase in pay, we know that his MPC out of that $500 increase in pay is 0.80.
Data for output (real income) and saving are presented in the table below. a. Fill in the missing numbers (gray-shaded cells) in the table. Instructions: In the table, round your answers to 4 decimal places. If you are entering any negative numbers be sure to include a negative sign (-) in front of those numbers 1. What is the value of the marginal propensity to consume? Instructions: Round your answers to one decimal place 2. What is the value of the marginal propensity to save? b. What is the break-even level of income in the table? Instructions: Enter your answer as a whole number. 3. Break-even level of income = What is the term that economists use for the saving situation shown at the $240 level of income? c. For each of the following items, indicate whether the value in the table is either constant or variable as income changes:
Consumption 244 260 APC=1.0000 APS=0.0000 276 292 308 APC=0.9625 APS= 0.0375 324 340 356 372 APC= 0.9300 APS= 0.0700 1. 0.8 2. 0.2 3. 260 Dissaving c. The MPS is constant as income changes. The APC is variable as income changes. The MPC is constant as income changes. The APS is variable as income changes. EXPLANATION: To find the level of consumption (column 2): Consumption = income - saving. Example: At income of $300, consumption = $300 - $8 = $292. To find the average propensity to consume (APC) (column 4): APC = consumption/income. Example: At income of $300, APC = $292/$300 = 0.9733. To find the average propensity to save (APS) (column 5): APS = saving/income. Example: At income of $300, APS = $8/$300 = 0.0267. To find the marginal propensity to consume (MPC) (column 6): MPC = Δconsumption/Δincome. Example: At income of $300 (from $280), MPC = $16/$20 = 0.8. To find the marginal propensity to save (MPS) (column 7): MPS = Δsaving/Δincome. Example: At income of $300 (from $280), MPS = $4/$20 = 0.2. b. The break-even level of income is where saving equals zero (consumption equals income). Thus, the break-even level of income is $260. At the $240 level of income, saving is negative. Economists refer to this as dissaving. c. MPS: Constant (does not change with income). APC: Variable (changes with income). MPC: Constant (does not change with income). APS: Variable (changes with income).
ADVANCED ANALYSIS Suppose that the linear equation for consumption in a hypothetical economy is: C = 40 + 0.8Y Also suppose that income (Y) is $400. Determine the values for the following: Instructions: For parts a, b, d, and f, round your answers to 1 decimal place. For parts c and e, enter your answers as whole numbers.
a. MPC = 0.8 b. MPS = 0.2 c. Consumption = $360 d. APC = 0.9 e. Saving = $40 f. APS = 0.1 EXPLANATION: a. MPC: The marginal propensity to consume is the slope of the linear equation, which equals 0.8. b. MPS: The marginal propensity to save is 1 minus the slope of the linear equation, which equals 0.2 (= 1 - 0.8). c. Consumption: To find the level of consumption, substitute income into the linear equation. This results in a level of consumption of $360 (= $40 + 0.8 × $400 = $40 + $320 = $360). d. APC: To find the average propensity to consume, divide consumption by income. This results in an average propensity to consume of 0.9 (= $360/$400). e. Saving: To find the level of saving, subtract consumption from income. This results in a level of saving of $40 (= $400 - $360). f. APS: To find the average propensity to save, divide saving by income. This results in an average propensity to save of 0.1 (= $40/$400).
Businesses in the nation of Islandia have been accumulating cash because they have a pessimistic outlook of the national economy. Recent changes in the economic outlook of Islandia have caused business leaders to begin to invest some of their accumulated cash. Suppose that businesses in the country invest a total of $10 billion of this cash. Instructions: Enter a positive number to show an increase and a negative number to show a decrease.
a. What would be the maximum expected change in GDP if Islandia's marginal propensity to consume (MPC) is 0.95? $200 Billion EXPLANATION: The impact on GDP will be greater than the additional amount invested because of the multiplier effect. This is because the money invested will go to wages, rent, interest, or profits. A portion of this additional money will be spent again in the economy, and the cycle will repeat until the amount that is spent becomes negligible. The portion that will be spent in each round of spending depends on the country's MPC. In this example, the MPC is 0.95, so for each dollar of wages, rent, interest, or profits received, 95 cents will be spent again in the economy. The multiplier can be calculated using the formula, Multiplier = 1/(1 − MPC). In our example, the multiplier = 1/(1 − 0.95) = 20. The change in GDP is found by multiplying the additional amount invested by the multiplier. Because the investment is additional money put into the economy, the change in GDP will be positive. For our example, the increase in GDP = 20 × $10 billion = $200 billion. We use the wording "maximum expected change" because factors that will be explained in future chapters cause the true multiplier to be somewhat less than the theoretical multiplier that we calculated. b. Suppose that the recent economic outlook in the country of Mountainia has been the opposite. Businesses have postponed planned investments and have begun to accumulate cash. If businesses in Mountainia postpone $15 billion of their planned investments, what would be the maximum expected change in GDP if its marginal propensity to save (MPS) is 0.1? -$150 Billion EXPLANATION: The reasoning for this example is similar to part a; however, accumulating cash because of postponed investment represents money taken out of the economy. Because investment is reduced, the multiplier effect will be negative, causing GDP to decrease. Alternatively, we could think of the money taken out of the economy as negative investment. For this example, we are given the MPS. We can calculate the multiplier by the formula, Multiplier = 1/MPS. So, in this case, our multiplier = 1/0.1 = 10. Therefore, the change in GDP = 10 × $-15 billion = $-150 billion.
The sum of the MPC and the MPS must equal 1 because
all additional income must be spent or saved. EXPLANATION:The change in the dollars spent or saved will appear in the numerator and together they must add to the total change in income. Since the denominator is the total change in income, the sum of the MPC and the MPS is 1.
A downshift of the consumption schedule typically involves an equal upshift of the saving schedule except when there is
an increase in personal taxes; then they both shift downward. EXPLANATION: If, by definition, all that you can do with your income is use it for consumption or saving, then if you consume less out of any given income, you will necessarily save more. This being so, when your consumption schedule shifts downward (meaning you are consuming less out of any given income), your saving schedule shifts upward (meaning you are saving more out of any given income).An exception to this occurs when a change in taxes shifts the consumption and saving schedules in the same direction. Taxes are paid partly at the expense of saving. So, an increase in taxes will reduce both consumption and saving.
The difference between the MPC and the APC is that the MPC is the
change in consumption divided by the change in income, whereas the APC is total consumption divided by total income. EXPLANATION: The MPC refers to changes in spending and income at the margin. Here we compare a change in consumer spending to a change in income: MPC = change in C/change in Y. The APC is an average whereby total spending on consumption (C) is compared to total income (Y): APC = C/Y.
The multiplier effect
intensifies the effect of a spending change, whether it is an increase or a decrease. EXPLANATION: The multiplier effect helps us understand why there is a business cycle as opposed to a stable level of output growth from year to year. In the Last Word, a "downturn" for one person became a downturn for everyone in that fictional economy. Likewise, if the story had begun with a burst of optimism and an increase in spending, it might have rippled through to expand everyone's fortunes. The multiplier intensifies the effect of a spending change, whether it is an increase or a decrease.
