ECON101 Module 8 (Exam 3)

Use the aggregate expenditures model and the following values to answer the next question. A MPC I G T $750 0.5 $1,000 $1,000 $500 Determine equilibrium consumption for this economy.

$3,000

Cost-push inflation is characterized by a(n)

decrease in aggregate supply and no change in aggregate demand.

With cost-push inflation in the short run, there will be a(n)

decrease real GDP

Planned investment is $20 billion and saving is $15 billion when GDP in the economy is $180 billion. The economy is

in disequilibrium and its GDP will increase

Which of the following statements describes the main idea behind Keynes's aggregate expenditures model?

the demand for labor and the level of production depend on the level of expenditure in an economy

If disposable income increases from $912 to $927 billion and MPC = 0.6, then consumption will increase by

$9 billion

A tax cut will have a greater effect on equilibrium GDP if the

marginal propensity to save is smaller

The American Recovery and Reinvestment Act (ARRA) of 2009, which is commonly known as the "stimulus," was aimed at:

reducing unemployment by increasing total expenditures

The economy experiences an increase in the price level and an increase in real domestic output. Which is a likely explanation?

net exports have increased

The anticipated increase in profit resulting from additional economic investment is known as the:

expected rate of return

Assuming that MPC is .75, equal increases in government spending and tax collections by $10 billion will

ncrease the equilibrium GDP by $10 billion

The labels for the axes of the aggregate demand graph should be

real domestic output on the horizontal axis and the price level on the vertical axis

Which of the following factors does not explain the inverse relationship between the price level and the total demand for output?

a substitution effect

An economy characterized by high unemployment is likely to be

having a recessionary expenditure gap

A decrease in expected returns on investment will most likely shift the AD curve to the

left because Ig will decrease

Generally speaking, the greater the MPS, the

smaller would be the increase in income that results from an increase in consumption spending

The table below shows the consumption schedule for a hypothetical economy. All figures are in billions of dollars. Real GDP Consumption $600 $590 610 598 620 606 630 614 640 622 650 630 660 638 If planned investments were fixed at $16, taxes were zero, government purchases of goods and services were zero, and net exports were zero, then equilibrium real GDP would be $630 initially. If government purchases were then raised from $0 to $10 and lump-sum taxes also increased from $0 to $10, other things constant, the equilibrium real GDP would become

$640

What is the slope of the consumption schedule or consumption line for a given economy?

1 - MPS

Answer the next question based on the following list of factors that are related to the aggregate demand curve. 1) Real-Balances Effect 2) Household Expectations 3) Interest-Rate Effect 4) Personal Income Tax Rates 5) Profit Expectations 6) National Income Abroad 7) Government Spending 8) Foreign Purchases Effect 9) Exchange Rates 10) Degree of Excess Capacity Changes in which two of the factors would most likely cause a shift in aggregate demand due to a change in consumer spending?

2 and 4

tax multiplier

Governments have two ways of affecting aggregate expenditures: directly through government purchases or indirectly through the amount of taxes they collect. The more taxes governments collect from households, the less disposable income households will have for consumption. The tax multiplier tells us how much output will eventually change for any initial change in taxes. It is directly related to the marginal propensity to consume: The greater the MPC, the greater the tax multiplier. The value of the tax multiplier is -MPC/1-MPC

cost-push and demand-pull inflation

In the AD-AS model, an increase in prices (inflation) can occur either because aggregate demand is increasing or aggregate supply is decreasing. The first case is what we call demand-pull inflation. It means that the economy experiences inflation because aggregate demand increases. The second case is what we call cost-push inflation. It means that the economy experiences inflation because aggregate supply decreases. Finally, the type of inflation (demand pull versus cost push) has important implications for the policies that government may use to control inflation and limit unemployment.

The saving schedule would be shifted upward by

a decrease in taxes

a. Compute the current MPC for each country. Country Change in Income Change in Consumption Adrup $9,500 $5,700 Bedrup 37,000 27,750 Cedrup 5,600 5,040 b. Which country has the highest marginal propensity to save (MPS)? c. If income in Bedrup increases by $300 and income in Cedrup increases by $600, which of the following statements is correct?

a. Adrup 0.6 Bedrup 0.75 Cedrup 0.9 b. Adrup c. Bedrup will save more dollars

a. Calculate the dollar amount of savings, the marginal propensity to consume (MPC), and the marginal propensity to save (MPS) for each level of income. After-Tax Income Consumption Spending $18,100 $ 9,000 23,100 13,500 29,975 19,000 37,975 24,600 b. Using the data in the table, the MPC _________ and the MPS _________ as income increases.

a. Savings MPC MPS $9,100 — — 9,600 0.9 0.1 10,975 0.8 0.2 13,375 0.7 0.3 b. decreases; increases

Which combination of factors would most likely increase aggregate demand?

an increase in consumer wealth and a decrease in interest rates

b. The $2,000 increase in net exports will immediately create an extra $2,000 in income, and some of that extra $2,000 of income will be directly spent. How much will expenditures increase when the economy reaches its new equilibrium? c. Using your answer in part b, or by computing the slope of the AE line above, what is the marginal propensity to consume for this nation? d. Using the graph, determine the equilibrium level of output before and after the $2,000 increase in net exports. This suggests a multiplier effect of _____

b. $1000 Note that the new AE line shows an expenditure value of $6,000 at the original output level of $6,000. The extra $2,000 is the increase in net exports. Since that extra $2,000 flows through as additional income for the aggregate population in this economy, the new level of income (real GDP) is $10,000. At the real GDP level of $8,000, for example, the new AE line shows an expenditure value of $9,000. This means that the extra $2,000 of additional income generates $1,000 of additional expenditure ($9,000 instead of $8,000 on the equilibrium line AE = Y). c. 0.5 So each $1 increase in income causes a $0.50 increase in expenditures. The marginal propensity to consume (MPC), which is computed as Change in Expenditures/Change in Income, is 0.5. Alternatively, we can compute the MPC by calculating the slope of the original AE line. As income changes from $0 to $14,000, aggregate expenditures change from $3,000 to $10,000. Thus, the slope is 7,000/14,000 = 0.5. d. before: 6000 after: 10000 multiplier effect: 2 According to the graph, the equilibrium level of output increased from $6,000 to $10,000 when net exports increased by $2,000. This suggests that the $2,000 increase in expenditures created a $4,000 increase in real GDP and that the multiplier effect must be 2. Alternatively, we can compute the expenditures multiplier as 1/(1 - MPC) = 1/(1 - 0.5) = 1/0.5, or 2.

a. How much do expenditures increase by after the economy experiences this change? $2,000 b. How much does equilibrium real GDP (Y) increase by after the economy experiences this change? $6,000 c. What is the value of the multiplier and the marginal propensity to consume (MPC) for this nation?

c. Multiplier: 3 MPC: 0.67

If the price level decreases, then the aggregate expenditures schedule will shift and this translates into a

movement down along the aggregate demand curve

indentifying inflationary and recessionary gaps

In the aggregate expenditures model, equilibrium output is determined by spending, and the resulting level of output may be above or below the full-employment level of real GDP. When output is below the full-employment level, a recessionary gap exists. When output is above the full-employment level, an inflationary gap exists. The size of the gap is equal to the size of the change in expenditures necessary to bring the economy back to full employment. To calculate this amount, divide the change in output necessary to return output to full employment by the expenditures multiplier.

a. According to the graph, this economy is currently experiencing a recessionary gap of $250. b. In the graph, show the shift in the aggregate expenditures schedule that establishes the full-employment level of output at $5,000. c. To restore the full-employment level of real output, aggregate expenditures must be increased by $250.

a. According to the graph, there is currently a recessionary gap of $250. A recessionary gap is the difference between expenditure when real GDP is below the full-employment level and the level of expenditure at full-employment real GDP. At the full-employment real GDP of $5,000, the current level of aggregate expenditures is $4,750, which is $250 short of equilibrium. Note that the size of the recessionary gap is not referring to the fact that the current equilibrium level of real GDP ($4,000) is $1,000 lower than the full-employment real GDP of $5,000. b. See the graph above. c. To restore the full-employment real GDP, expenditures must be increased by $250. If done correctly, $5,000 would become the equilibrium level of output.

A tax-cut will have a greater effect on equilibrium GDP if the

marginal propensity to save is smaller

A lower real interest rate typically induces consumers to

purchase more goods that are bought using credit

Saving is $40 billion and planned investment is $28 billion at the $175 billion level of output in a private closed economy. At this level

unplanned investment will be positive $12 billion

aggregate demand

The first part of the aggregate demand and supply model is the aggregate demand curve. The AD curve shows the relationship between the total amount of goods and services demanded (or aggregate expenditure) and the overall price level. For reasons that will be developed over the course of this topic, at a lower price level the amount of goods and services demanded increases. Thus, there is a negative relationship between the price level and aggregate demand. As such, we draw the aggregate demand curve as a downward-sloping line—similar to the way we draw the demand curve for an individual good or service.

investment, government purchases, and net exports schedules

When real GDP increases, consumers spend some of the extra income and save the rest. When it comes to the other three components of aggregate expenditures (investment, government purchases, and net exports), the aggregate expenditures model assumes there is no such positive relationship between real GDP and spending. The aggregate expenditures model assumes that these three components of aggregate expenditures are determined independently of real GDP, so changes in real GDP do not affect them. However, these three types of spending are important because they will change as a result of government policies and shocks to the economy, which will affect aggregate expenditures and, as a result, income.

The table below shows the annual consumption expenditure (C) and output (Y) for a fictitious nation. We assume that there are no taxes in this nation, so disposable income (DI) is the same as income (Y). Furthermore, we know that at the current real interest rate, gross investment (I) is $300, government purchases (G) are $300, and net exports (NX) are -$100. Note that the negative net exports value implies that imports are greater than exports for this nation. a. Using the table below, compute the value for aggregate expenditures (AE = C + I + G + NX) for each level of output. Real GDP (Y) Consumption (C) $0 $500 1,000 1,250 2,000 2,000 3,000 2,750 4,000 3,500 5,000 4,250 b. What is the equilibrium level of output?

a. Aggregate Expenditures (AE) $1000 1750 2500 3250 4000 4750 b. $4000

determinants of aggregate demand - government and net exports spending

Spending decisions made by government, as well as a variety of factors that affect international trade, have important implications for aggregate demand in the economy: If government purchases increase, aggregate demand increases, causing the aggregate demand curve to shift to the right. If government purchases decrease, aggregate demand decreases, causing the aggregate demand curve to shift to the left. Likewise, net exports affect aggregate demand in the economy: Increases in net exports increase aggregate demand, causing the aggregate demand curve to shift to the right. Decreases in net exports decrease aggregate demand, causing the aggregate demand curve to shift to the left.

determinants of aggregate supply - resource prices and productivity

Aggregate supply represents the aggregate quantity of real GDP supplied in an economy at various price levels, all else held constant. Three key determinants of aggregate supply are the cost of resources, the productivity of resources, and social institutions like government regulations. If any of these determinants changes, aggregate supply will change as well. The cost of resources has these effects: An increase in the cost of resources will reduce the aggregate quantity supplied at a given price level, causing a decrease in aggregate supply and shifting the aggregate supply curve to the left. A decrease in the cost of resources will increase the aggregate quantity supplied, at every price, shifting the aggregate supply curve to the right. Productivity has exactly the opposite effect: If productivity rises, aggregate supply increases. If productivity falls, aggregate supply falls. Social institutions that affect the cost of doing business can also shift aggregate supply: Rules or regulations that make it more expensive to produce output will decrease aggregate supply. Rules or regulations that make it easier to be productive will increase aggregate supply.

consumption and income

Autonomous consumption is equal to consumption expenditure when income equals zero. That consumption is funded by drawing on savings or by borrowing. Notice that the marginal propensity to consume (MPC) can be found by taking the change in C and dividing by the change in Y (real GDP): thus, the slope of the consumption function is also the MPC. PART C: Draw the equilibrium line representing the combinations of consumption and real GDP that are equal to each other. Solution: A line through the origin with a slope of 1 (or 45 degrees, depending on whether you prefer to express lines in slopes or degrees) would show all the combinations of consumption and real GDP that are equal. Note that at any point on this line, the length of a line from the point straight down to the x axis (which would be the amount of consumption) is equal to the length of the line from the point straight across to the y axis (which is the amount of real GDP). What happens to consumption when a person's income increases? As income increases, most people consume a fraction of the additional income and save the rest. Thus, there is a positive relationship between income and consumption. If we graph this relationship, we create a consumption schedule —the first piece in our aggregate expenditures model. The slope of the consumption schedule is equal to the marginal propensity to consume (MPC). The larger the MPC, the steeper the consumption schedule. Equilibrium in the aggregate expenditures model occurs when aggregate expenditures are equal to output. We can express this concept with an equilibrium line (or 45-degree line): the line that shows all possible equilibriums in the economy, points at which aggregate expenditure is equal to output. Equilibrium consumption occurs where the consumption schedule intersects with the equilibrium line.

expenditures multiplier

In the aggregate expenditures model, consumption depends positively on income: The more income you have, the more you will consume. As a result, there is a multiplier effect whenever spending rises: Output increases to match the increased desire to buy goods and services. That output becomes income for someone else, who will want to spend some of that income on increased consumption. The expenditures multiplier tells us how much output will eventually increase for any initial change in income. It is directly related to the marginal propensity to consume, and the formula for it is (1/1-MPC) The greater the MPC, the greater the expenditures multiplier will be. The expenditures multiplier is important for predicting how much output will eventually change when a change in spending occurs. It can help government determine how much it needs to spend if it wants output to change by a specific amount.

aggregate supply in the short run

In the short run, aggregate supply is an upward-sloping curve: The higher the overall price level, the more output is produced in the economy; and the lower the overall price level, the less output is produced. One reason why firms produce more output when the overall price level rises is this: Higher prices result in greater revenue for the firm, which encourages more production. A fundamental assumption of this model is that input prices (of which wages are the most important) are constant because they are sticky and take time to adjust.

investment demand curve

Investment occurs when a firm purchases new capital goods to replace worn-out equipment or to expand production. When firms consider investment, they compare the expected rate of return on the investment (the marginal benefit of investment) to the opportunity cost of the investment (the marginal cost). The opportunity cost of the investment is directly related to the interest rate, since firms either borrow for investment or use funds that could be earning interest. At lower interest rates, firms find it more profitable to undertake more investment projects, and the quantity of investment demanded increases. At higher interest rates, the quantity of investment demanded decreases. Thus, the investment demand curve, which shows the quantity of investment versus the interest rate, is a downward-sloping curve.

savings and income

PART A: Use the fact that the marginal propensity to consume in Zamunda is 0.8 to complete the table. Solution: Since every dollar of disposable income must be either spent or saved, if the marginal propensity to consume is 0.8, then the marginal propensity to save must be 0.2. Thus, every time income increases by $1,000, consumption increases by $800 and savings increases by $200. As income increases, most people will consume a fraction of the additional income and will save the rest. If we graph the relationship between income and savings, we create a savings schedule that shows how much is saved at different levels of income. In a simple aggregate expenditures model, the only component of spending is consumption; at equilibrium in that model, consumption is equal to real GDP. Thus, savings equals zero since all income is consumed. Savings becomes positive for the economy as a whole once we add other sectors (investment, government spending, and net exports) to make the model better reflect the real world.

real balances, interest rates, and foreign purchases

PART A: You used to withdraw $80 from the bank to spend each weekend. When the overall price level rises, you would need to withdraw $100 to make the same purchases you did before. Solution: This scenario describes an increase in your demand for money. As a result of this change, banks will have to charge higher interest rates to keep the quantity of money demanded equal to the quantity of money supplied. Thus, this scenario is an example of the interest-rate effect. PART B: When the overall price level rises, it becomes cheaper for you to take a trip to Mexico than to take a trip to Florida. Solution: When you travel abroad, you buy leisure and recreation services that are produced in another country. Foreign travel is considered an import. A higher domestic price level causes you to increase your "imports of" Mexican leisure and recreation services. This is an example of the foreign-purchases effect. It is also more likely that people in Mexico will reduce the amount of U.S. products they purchase, so U.S. exports will fall. The combined effect of increased imports into the United States and decreased exports from the United States causes aggregate expenditures to fall. PART C: When the overall price level rises, the $200 you have in your savings account, which used to allow you to purchase four video games, now can buy only three video games. Solution: Although your $200 is still $200, the amount of output that it can purchase has decreased. Thus, the real value of your wealth has fallen, and you are forced to decrease your consumption. This is an example of the real-balances effect. The aggregate demand curve slopes downward due to the real-balances, interest-rate, and foreign-purchases effects: When the price level rises, the real value of people's nominal assets (like money) falls, reducing the real value of their nominal wealth. The result is that consumption spending will decrease, since not as much output can be purchased as before. Likewise, a higher price level means that if you borrow money to buy a good or service, you'll need to borrow more than before, causing interest rates to rise. Higher interest rates mean less consumption and investment spending. Finally, if the price level rises, domestically produced goods become more expensive relative to foreign goods, which causes net exports to fall. Each of these effects, individually or together, will cause the aggregate demand curve to be downward-sloping.

marginal propensities to consume and save

PART B: In which country would an increase in income lead to the largest change in consumption? Solution: The country that would have the largest change in consumption is the country that has the largest MPC. PART C: In which country would an increase in income lead to the largest change in savings? Solution: The country that would have the largest change in savings as a result of a change in income is the country with the largest MPS. Since MPC + MPS = 1, the country with the highest MPS must also have the lowest MPC. After you've paid your taxes, you can do two things with an additional dollar of disposable income: spend it or save it. The fraction of each additional dollar that you choose to spend is called the marginal propensity to consume (MPC). The fraction that you save is called the marginal propensity to save (MPS). Because you must either spend the dollar or save it, MPC + MPS = 1. To determine the value of the MPC for an economy, we can observe a given increase in income (∆Y), see how much of it is spent on consumption (∆C), and then calculate MPC = ∆C/∆Y.

equilibrium - recessions and expansions

PART C: What can we say about the individual values of consumption (C), gross investment (I), government purchases (G), and net exports (NX) when we compare the new long-run equilibrium found in Part B to the original one presented in the problem? Solution: In the long run, output returns to its initial level, so when we add up C + I + G + NX, the result is the same. But the composition of spending in the economy has changed: We know that Florin's government purchases have increased as a result of the war with Guilder. So when and how did C, I, or NX decrease? Two changes had the effect of decreasing C, I, and NX: The increase in the price level, from 100 to 105, when aggregate demand increased. The increase in the price level again, from 105 to 110, when aggregate supply decreased. Why? Remember the three reasons the aggregate demand curve is downward-sloping: the real-balances, interest-rate, and foreign-purchases effects. Those three reasons indicate that when the price level rises, consumption, investment spending, and net exports will decrease—each for its own specific reason. The aggregate demand and aggregate supply model can help explain the business cycle. If a decrease in either aggregate demand or aggregate supply occurs in the economy, output will fall below its full-employment level, taking the economy into a recession. Over time, as nominal wages and other input prices fall, aggregate supply increases, and output begins to increase: The economy hits its trough and starts to recover. Similarly, if an increase in aggregate demand or supply occurs, the economy will experience an expansion, with output reaching levels above full employment. But the good times won't last forever; eventually nominal wages and other input prices will rise, resulting in a decrease in aggregate supply. As such, output in the economy returns to the full-employment level in the long run. Thus, it is the natural adjustments that occur in input markets that eventually bring the economy back to long-run equilibrium.

equilibrium dynamics

The aggregate demand and aggregate supply (AD-AS) model allows us to explain how a variety of different events will affect the economy, in both the short run and the long run. If the aggregate demand or aggregate supply curve shifts, the short-run equilibrium will be at a level of output that is no longer the full-employment level of output. Over time, however, as input prices adjust in the long run, the aggregate supply curve will shift to reflect the new price of inputs, moving the economy back to its long-run level of output. The short-run level of output in regard to the full-employment level affects the change in input prices and shift of the aggregate supply curve, as follows: If output is above the full-employment level, input prices (especially wages) tend to increase, which shifts the aggregate supply curve to the left. If output is below the full-employment level, input prices will decrease, which shifts the aggregate supply curve to the right. Thus, the mechanism by which the economy returns to the full-employment level is changes in input prices. If input prices, like wages, tend to be sticky for fairly long periods of time, the adjustment process may take a long time. This opens the door for the government to use fiscal or monetary policy to shift the aggregate demand curve, bringing us back to the full-employment level of output more quickly.

aggregate expenditures and aggregate demand

The aggregate demand curve extends the aggregate expenditures model by creating a linkage between expenditures in the economy and the price level. As the price level changes, expenditures—and thus aggregate demand—change as well: If the price level rises, the quantity of real GDP demanded (aggregate expenditure) falls. If the price level falls, the quantity of real GDP demanded (aggregate expenditure) rises. As a result, the aggregate demand curve is downward-sloping. The key is to understand that each point on the aggregate demand curve is an equilibrium in the aggregate expenditures model. Thus, the aggregate expenditures model is embedded within our aggregate demand model. So some of the implications of the AE model, like the expenditures multiplier and the tax multiplier, will carry over to our aggregate demand model.

determinants of aggregate demand - taxes and consumer and investment spending

The aggregate demand curve represents the relationship between the price level and the quantity of real GDP demanded, all else held constant. If any of the components of aggregate demand change, the aggregate demand curve will shift. For example: An increase in consumption expenditures will shift the aggregate demand curve to the right. A decrease in consumption expenditures will shift the aggregate demand curve to the left. The same is true for investment spending: An increase in investment spending will shift the aggregate demand curve to the right. A decrease in investment spending will shift the aggregate demand curve to the left. Changes in aggregate demand are one of the major explanations for fluctuations in output in the aggregate demand and aggregate supply model.

introduction to aggregate expenditures

The aggregate expenditures model proposes that total spending (aggregate expenditures) in an economy will, in equilibrium, be equal to total output. In this model, aggregate expenditures are classified into four different categories, which are identified by who is buying the output: consumption by households, investment by firms, government purchases, and net exports. If any of these types of spending increase, aggregate expenditures will also increase; firms will have to produce more output to meet the additional demand. Thus, an increase in aggregate expenditures will lead to an increase in real GDP.

aggregate supply in the long run

The long-run aggregate supply curve (LRAS) represents the level of output produced when an economy is in long-run equilibrium and all resources are being fully and properly utilized. This is the level of output that corresponds to full employment, or the point at which the unemployment rate in the economy is equal to its natural rate. When an economy is producing at its long-run equilibrium, prices are stable and there is no cyclical unemployment. The long-run equilibrium is represented graphically as a vertical line at the full-employment level of real GDP. Output may be above the full-employment level in the short run due to a higher price level, but eventually input prices will increase to bring output back down. If output is below this level in the short run as a result of a lower price level, eventually input prices will decrease to bring output back up.

aggregate demand and aggregate supply in equilibrium

When we combine the aggregate demand and aggregate supply curves, we see that the intersection of the two determines the short-run equilibrium price level and the level of real GDP in the economy. In the long run, output will be at the full-employment level of output determined by the economy's resources, technology, and social institutions. Thus, LRAS and AD determine the price level in the long run; AS adjusts to intersect the other two curves. The economy is at both short-run and long-run equilibrium if all three curves—aggregate demand, aggregate supply, and long-run aggregate supply—intersect at the full-employment level of output. Natural disasters, economic shocks, and government policies can affect both the AS and AD curves, moving us away from full employment in the short run. Eventually, input prices will adjust until we return to the full-employment level.

stagflation

Until the 1970s, macroeconomic fluctuations occurred mainly as a result of changes in aggregate demand: When aggregate demand increased, inflation increased but unemployment fell. And when aggregate demand decreased, unemployment increased but inflation fell. Thus, there was a negative relationship between the unemployment rate and the inflation rate. However, the economy of the 1970s experienced a significant increase in input costs. The result was an increase in both the inflation rate and the unemployment rate, a situation we now refer to as stagflation.

equilibrium dynamics

When there is an increase in any type of expenditure—C, I, G, or NX—the multiplier process begins. Output rises from the initial change in expenditures, and the increased income that results causes households to increase their consumption. Ultimately, output rises by more than the initial increase in expenditures because of the increased consumption spending. The total change in output will be equal to the expenditures multiplier times the initial increase in spending. The proportion of this increase that is from increased consumption is equal to the marginal propensity to consume. Finally, the adjustment process can take years to complete.

aggregate expenditures model equilibriums

When you know the relationship between income and the four categories of spending (consumption, gross investment, government purchases, and net exports), you can combine them to develop aggregate expenditures. Of the four categories of spending, only consumption depends on income, so the slope of the aggregate expenditures line is the same as the slope of the consumption schedule: the marginal propensity to consume (MPC). Equilibrium in the economy occurs when aggregate expenditures are equal to the amount of output produced, AE = Y. If any part of AE (G, I, or NX) increases, the AE curve will shift up, resulting in higher equilibrium real GDP in the economy.

The graph below shows the consumption schedule for Zamunda. Research has yielded the following information about Zamunda: At the current interest rate, gross investment (I) is $500, government purchases (G) are $800, exports are $400, and imports are $200. a. By supplementing the consumption schedule in the graph below to include the expenditures for gross investment (I), government purchases (G), and net exports (NX) stated above, what is the new value of the vertical intercept? c. Calculate the slope of the consumption schedule before the inclusion of I + G + NX. Then calculate the slope of the entire aggregate expenditures schedule (C + I + G + NX). d. The slope of the aggregate expenditures schedule (C + I + G + NX) represents ____________

a. 23,500 c. Before the inclusion of I + G + NX: 0.5 Entire aggregate expenditures schedule: 0.5 d. the MPC Notice that the marginal propensity to consume (MPC) is found by taking the change in consumption and dividing by the change in real GDP. So the slope must be the MPC

Your research into a nation has yielded the following information: Autonomous expenditure (A) = $3,000 Gross investment (I) = $2,000 Government purchases (G) = $2,500 Net exports (NX) = -$1,000 Taxes (T) = $2,000 MPC = 0.75 a. Substitute the values above into the equation: AE = A + [MPC × (Y - T)] + I + G + NX. Then state the abbreviated equation for aggregate expenditures (AE). b. Using the abbreviated equation you computed in part a, complete the table below. Real GDP (Y) AE $0 ? 8,000 ? 16,000 ? 24,000 ? c. Knowing that AE = Y at the equilibrium level of output, what is the equilibrium level of output for this nation? d. What is the expenditures multiplier for this economy? e. If government purchases increase by $1,000, from $2,500 to $3,500, what will be the new equilibrium level of output?

a. AE = 5,000 + 0.75Y Note that the equation AE = A + [MPC × (Y - T)] + I + G + NX has several components that are independent of the level of real output (Y). We can therefore start by substituting in those values: AE = A + [MPC × (Y - T)] + I + G + NX AE = 3,000 + [0.75 × (Y - 2,000)] + 2,000 + 2,500 - 1,000 AE = 3,000 + 0.75Y - 0.75 × 2,000 + 2,000 + 2,500 - 1,000 AE = 3,000 - 1,500 + 2,000 + 2,500 - 1,000 + 0.75Y AE = 5,000 + 0.75Y b. Aggregate Expenditures (AE) $5000 11000 17000 23000 Using the equation 5,000 + 0.75Y, we can solve for AE at each level of output: When Y = 0, then AE = 5,000 + 0.75(0) = 5,000 When Y = 8,000, then AE = 5,000 + 0.75(8,000) = 11,000 When Y = 16,000, then AE = 5,000 + 0.75(16,000) = 17,000 When Y = 24,000, then AE = 5,000 + 0.75(24,000) = 23,000 c. Ye: 20,000 At the equilibrium level of output: Y = AE Y = AE = A + [MPC × (Y - T)] + I + G + NX Y = A + [MPC × (Y - T)] + I + G + NX Y - MPC × Y = A + (MPC × T) + I + G + NX Y (1 - MPC) = A + (MPC × T) + I + G + NX Ye = [A + (MPC × T) + I + G + NX]/(1 - MPC) Ye = [3,000 - 1,500 + 2,000 + 2,500 - 1,000]/(1 - 0.75) Ye = 5,000/0.25 = 20,000 d. 4 Note that the MPC of 0.75 suggests an expenditures multiplier of 4, from 1/(1 - MPC) or 1/0.25. So an increase in G (or any of the values G, I, NX, and A) by 1 will increase real GDP by 4. e. Ye: 24,000 The new equilibrium level of output can be computed either using the expenditures multiplier computed in part d: 20,000 + (4 - 1,000) = 20,000 + 4,000 = 24,000. Alternatively, we can solve using the same equation used for part c: Ye = [A + (MPC - T) + I + G + NX] / (1 - MPC) Ye = [3,000 - 1,500 + 2,000 + 3,500 - 1,000] / (1 - 0.75) Ye = 6,000 / 0.25 = 24,000

Suppose a country's MPC is 0.8, and in this country, government seeks to boost real GDP by either increasing government purchases by $50 billion or by reducing taxes by the same amount. a. If it increases government purchases, real GDP will increase by $250 billion, suggesting an expenditures multiplier of 5. If the government instead lowers taxes, real GDP will increase by $200 billion, suggesting a tax multiplier of -4. b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount. If it decreases government purchases, real GDP will decrease by $125 billion, suggesting an expenditures multiplier of 2.5. If the government instead raises taxes, real GDP will decrease by $75 billion, suggesting a tax multiplier of -1.5. c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?

a. We already know that the expenditures multiplier is computed as 1/(1 - MPC) or 1/MPS. For this country, the expenditures multiplier = 1/(1 - 0.8) = 1/0.2 = 5. So a $50 billion increase in government purchases will result in a $250 billion increase in real GDP ($50 billion × 5). The tax multiplier is computed as - MPC/(1 - MPC) or - MPC/MPS. For this economy, the tax multiplier equals -0.8/0.2 = -4. Therefore, a $50 billion decrease in taxes will result in a $200 billion increase in real GDP (-$50 billion × -4). b. Again, the expenditures multiplier is computed as 1/(1 - MPC) or 1/MPS. For this country, the expenditures multiplier = 1/(1 - 0.6) = 1/0.4 = 2.5. So a $50 billion decrease in government purchases will result in a $125 billion decrease in real GDP ($50 billion × 2.5). Since the tax multiplier is computed as - MPC/(1 - MPC) or - MPC/MPS, the tax multiplier for this economy equals -0.6/0.4 = -1.5. Therefore, a $50 billion increase in taxes will result in a $75 billion decrease in real GDP ($50 billion × -1.5). c. The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut. In terms of magnitude, note that the tax multiplier is smaller in both a and b. This difference in the two multipliers comes from the different effects on output of the very first transaction—the $50 billion going to or going from the government in this question. If the government uses $50 billion for government purchases, $50 billion in newly produced goods and services is being produced in the economy in exchange for that money. However, if the government instead reduces taxes by $50 billion, nothing new is initially created in the economy. That money is given by the government to the people, but no output is produced in the process. Output begins to increase once citizens use that money to buy something new. And note that only the MPC of that extra disposable income ($50 billion) will actually be spent, as households will save a portion of their extra income.

Assume that any taxes in this country are a fixed sum so that changes in disposable income are the same as changes in real GDP. In this case, the slope represents __________

the MPC Notice that the marginal propensity to consume (MPC) is found by taking the change in consumption (C) and dividing by the change in real GDP (Y). If the change in disposable income is equal to the change in real GDP (Y), then the slope must be the MPC

Assume that any taxes in this economy are a fixed sum so that changes in disposable income are the same as changes in real GDP. In this case, the slope represents ___________

the MPS Notice that the marginal propensity to save (MPS) can be found by taking the change in savings (S) and dividing it by the change in real GDP (Y). If the change in disposable income is equal to the change in real GDP, then the slope must be the MPS