Macro Test #3

Explain why a $500 million increase in government purchases of goods and services will generate a larger rise in real GDP than a $500 million increase in government transfers.

A $500 million increase in government purchases of goods and services directly increases aggregate spending by $500 million, which then starts the spending multiplier in motion. It will increase real GDP by $500 million × 1/(1 − MPC ). A $500 million increase in government transfers increases aggregate spending only to the extent that it leads to an increase in consumer spending. Consumer spending rises by MPC × $1 for every $1 increase in disposable income, where MPC is less than 1. Thus, a $500 million increase in government transfers will cause a rise in real GDP only MPC times as much as a $500 million increase in government purchases of goods and services. It will increase real GDP by $500 million × MPC /(1 − MPC ).

Explain why a decline in investment spending caused by a change in business expectations leads to a fall in consumer spending.

A decline in investment spending has a multiplier effect on real GDP. The fall in actual investment spending, I, leads to an initial fall in real GDP, which leads to a fall in disposable income (because less production means a decrease in payments to workers), which leads to lower consumer spending, which leads to another fall in real GDP, and so on. Thus, consumer spending falls as an indirect result of the fall in investment spending.

a sharp rise in the interest rate

A rise in the interest rate means that fewer investment spending projects are now profitable to producers, whether they are financed through borrowing or retained earnings. As a result, producers will reduce the amount of planned investment spending.

a sharp increase in the economy's growth rate of real GDP

A sharp increase in the rate of real GDP growth leads to a higher level of planned investment spending by producers as they increase production capacity to meet higher demand.

Congress raises taxes and cuts spending.

An increase in taxes and a reduction in government spending both result in negative demand shocks, shifting the aggregate demand curve to the left. As a result, both the aggregate price level and aggregate output fall

Short run effects on agg price level and output if The government sharply increases the minimum wage, raising the wages of many workers.

An increase in the minimum wage raises the nominal wage and, as a result, shifts the shortrun aggregate supply curve to the left. As a result of this negative supply shock, the aggregate price level rises and aggregate output falls.

For each event, explain whether the initial effect is a change in planned investment spending or a change in unplanned inventory investment, and indicate the direction of the change. an unexpected increase in consumer spending

An unexpected increase in consumer spending will result in a reduction in inventories as producers sell items from their inventories to satisfy this short-term increase in demand. This is negative unplanned inventory investment: it reduces the value of producers' inventories.

Suppose a rise in productivity increases potential output and creates a recessionary gap. Explain how the economy can self-correct in the long run.

As economic growth increases potential output, the long-run aggregate supply curve shifts to the right. If, in the short run, a recessionary gap (aggregate output is less than potential output) now exists, nominal wages will fall, shifting the short-run aggregate supply curve to the right. This results in a fall in the aggregate price level and a rise in aggregate output. As prices fall, we move along the aggregate demand curve due to the wealth and interest rate effects of a change in the aggregate price level. Eventually, as long-run macroeconomic equilibrium is reestablished, aggregate output will rise to become equal to potential output, and the aggregate price level will fall to the level that equates the quantity of aggregate output demanded with potential output.

an unanticipated fall in sales

As sales fall, producers sell less, and their inventories grow. This leads to positive unplanned inventory investment.

The country of Boldovia has no unemployment insurance benefits and a tax system that uses only lump-sum taxes. The neighboring country of Moldovia has generous unemployment benefits and a tax system in which residents must pay a percentage of their income. Which country will experience greater variation in real GDP in response to demand shocks, positive and negative? Explain.

Boldovia will experience greater variation in its real GDP than Moldovia because Moldovia has automatic stabilizers while Boldovia does not. In Moldovia, the effects of slumps will be lessened by unemployment insurance benefits, which will support residents' incomes, while the effects of booms will be diminished because tax revenues will go up. In contrast, incomes will not be supported in Boldovia during slumps because there is no unemployment insurance. In addition, because Boldovia has lump-sum taxes, its booms will not be diminished by increases in tax revenue.

Rise in GDP formula

I=1/(1-MPC)

Suppose a crisis in the capital markets makes consumers unable to borrow and unable to save money. What implication does this have for the effects of expected future disposable income on consumer spending?

If you expect your future disposable income to fall, you would like to save some of today's disposable income to tide you over in the future. But you cannot do this if you cannot save. If you expect your future disposable income to rise, you would like to spend some of tomorrow's higher income today. But you cannot do this if you cannot borrow. If you cannot save or borrow, your expected future disposable income will have no effect on your consumer spending today. In fact, your MPC must always equal 1: you must consume all your current disposable income today, and you will be unable to smooth your consumption over time.

Solar energy firms launch a major program of investment spending.

Increased investment spending shifts the aggregate demand curve to the right. As a result of this positive demand shock, both the aggregate price level and aggregate output rise.

A decrease in which of the following will cause the short-run aggregate supply curve to shift to the left?

Productivity

Explain why the tax multiplier is smaller than the spending multiplier for a decrease in government purchases.

The tax multiplier is relatively small because the initial change in spending is relatively small. For each $1 increase in taxes, the initial decrease in spending is only the MPC , whereas a $1 decrease in government purchases decreases spending by a full $1.

Severe weather destroys crops around the world.

This is a negative supply shock, shifting the short-run aggregate supply curve to the left. As a result, the aggregate price level rises and aggregate output falls.

Shift or Movement? A rise in the consumer price index (CPI) leads producers to increase output.

This represents a movement along the SRAS curve because the CPI—like the GDP deflator—is a measure of the aggregate price level, the overall price level of final goods and services in the economy.

Shift or Movement? A rise in legally mandated retirement benefits paid to workers leads producers to reduce output.

This represents a shift of the SRAS curve because it involves a change in nominal wages. An increase in legally mandated benefits to workers is equivalent to an increase in nominal wages. As a result, the SRAS curve will shift leftward because production costs are now higher, leading to a lower quantity of aggregate output supplied at any given aggregate price level.

Shift or Movement? A fall in the price of oil leads producers to increase output.

This represents a shift of the SRAS curve because oil is a commodity. The SRAS curve will shift to the right because production costs are now lower, leading to a higher quantity of aggregate output supplied at any given aggregate price level.

What is the spending multiplier if the marginal ropensity to consume is 0.5? What is it if MPC is 0.8?

When MPC is 0.5, the spending multiplier is equal to 1/(1 - 0.5) = 1/0.5 = 2. When MPC is 0.8, the spending multiplier is equal to 1/(1 - 0.8) = 1/0.2 = 5.

Suppose the economy is initially at potential output and the quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS curve or a shift of the LRAS curve?

You would need to know what happened to the aggregate price level. If the increase in the quantity of aggregate output supplied was due to a movement along the SRAS curve, the aggregate price level would have increased at the same time as the quantity of aggregate output supplied increased. If the increase in the quantity of aggregate output supplied was due to a rightward shift of the LRAS curve, the aggregate price level might not rise. Alternatively, you could make the determination by observing what happened to aggregate output in the long run. If it fell back to its initial level in the long run, then the temporary increase in aggregate output was due to a movement along the SRAS curve. If it stayed at the higher level in the long run, the increase in aggregate output was due to a rightward shift of the LRAS curve.

Marginal Propensity to Save (MPS)

additional disposable income that is saved. The increase in household savings when disposable income rises by $1

Autonomous changes in aggregate spending

an initial rise or fall in aggregate spending that is the cause, not the result, of a series of income and spending changes

MPC formula

change in consumption/change in disposable income

Factors that will shift the SRAS

profit per unit at any given price level, commodity prices, nominal wages, productivity

Marginal Propensity to Consume (MPC)

the increase in consumer spending when disposable income rises by $1

Spending multiplier

the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change; it indicates the total rise in real GDP that results from each $1 of an initial rise in spending