Econ Chapter 10

The saving schedule shows the relationship of saving of households to the level of

disposable income

The multiplier effect

intensifies the effect of a spending change, whether it is an increase or a decrease. Multiplier = 1/(1 − MPC)

Assume that an increase in a household's disposable income from $40,000 to $48,000 leads to an increase in consumption from $35,000 to $41,000, then the

slope of the consumption schedule is 0.75.

In what direction will each of the following occurrences shift the consumption and saving schedules, other things equal?

A large decrease in real estate values, including private homes. The consumption schedule will shift downward. The saving schedule will shift upward A sharp, sustained increase in stock prices. The consumption schedule will shift upward The saving schedule will shift An economy-wide expectation that a recession is over and that a robust expansion will occur. The consumption schedule will shift upward The saving schedule will shift downward A substantial increase in household borrowing to finance auto purchases. The consumption schedule will shift upward The saving schedule will shift downward A. The consumption schedule will shift downward and the saving schedule will shift upward given the decrease in wealth. b. The consumption schedule will shift upward and the saving schedule will shift downward given the increase in wealth. c. The consumption schedule will shift upward and the saving schedule will shift downward because individuals expect to be earning higher income in the future. d. The consumption schedule will shift upward and the saving schedule will shift downward as individuals borrow (decrease saving) and purchase automobiles (increase consumption).

Refer to the table below and suppose that the real interest rate is 6 percent. Next, assume that some factor changes such that the expected rate of return declines by 2 percentage points at each prospective level of investment. Real Interest Rate (i) and Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (Billions per Year) 16% $0 14 5 12 10 10 15 8 20 6 25 4 30 2 35 0 40

Assuming no change in the real interest rate, by how much and in what direction will investment change? Based on the table, for every 2 percentage point drop in interest rate or for every 2 percentage point increase in return, investments will increase by $5 billion. Since the expected rate of return at each level of investment has decreased, investment will decrease by $5 billion at each level of investment. Because the level of investment is now less at each level of interest rate, the investment schedule has shifted to the left. Investment will decrease 5 Billion .2X25=5 The investment schedule will shift to the left b.Which of the following might cause this change? An increase in excess production capacity

Refer to the accompanying figures, with consumption schedules in figure (A) and saving schedules in figure (B), which correspond to each other across different levels of disposable income. If, in figure (A), consumption shifts from A2 to A3 because of a change in taxes, then in figure (B) line

B2 will shift to B3.

What are the variables (the items measured on the axes) in a graph of the (a) consumption schedule and (b) saving schedule? Are the variables inversely (negatively) related or are they directly (positively) related?

Consumption schedule The variable on the vertical (y) axis is consumption Correct and the variable on the horizontal (x) axis is disposable income . These variables are directly related. aving schedule The variable on the vertical (y) axis is saving Correct and the variable on the horizontal (x) axis is disposable income. These variables are directly related. c. What is the fundamental reason that the levels of consumption and saving in the United States are each higher today than they were a decade ago? Real GDP and disposable income are higher.

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?

MPC = change in consumption / change 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.

What will the multiplier be given the MPS values below? Fill in the table with your answers. 0.4= 2.50 correct 0.5 =2.00correct 1.0 =1.00

The multiplier = 1/MPS = 1/(1 - MPC). When the MPS = 0, the multiplier is infinity, or undefined. When the MPS is 0.4, the multiplier is 2.5 (= 1/0.4). When the MPS is 0.5, the multiplier is 2.0 (= 1/0.5). When the MPS is 1, the multiplier is 1 (= 1/1).

How much of a change in GDP will result if firms increase their level of investment by $8 billion and the MPC instead is 0.67?

The multiplier here is 5 (= 1/(1 - 0.8)). We multiply this times the initial change in investment to find the complete effect on GDP. GDP will change by $40 billion (= 5 × $8 billion). If the MPC were instead 0.67, the change in GDP equals $24 billion (approximately). In this case, the multiplier is 3 (approximately). 24 Billion

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. $240 $244 $4 1.0167 0.0167 0.8 0.2 260 260 0 1.0000 0.0000 0.8 0.2 280 276 4 0.9857 0.0143 0.8 0.2 300 292 8 0.9733 0.0267 0.8 0.2 320 308 12 0.9625 0.0375 0.8 0.2 340 324 16 0.9529 0.0471 0.8 0.2 360 340 20 0.9444 0.0556 0.8 0.2 380 356 24 0.9368 0.0632 0.8 0.2 400 372 28 0.9300 0.0700 0.8 0.2

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).

Suppose that an initial $10 billion increase in investment spending expands GDP by $10 billion in the first round of the multiplier process. Also suppose that GDP and consumption both rise by $6 billion in the second round of the process.

What is the MPC in this economy? The initial $10 billion increase in investment spending expands GDP by $10 billion and income by $10 billion. Since consumption increases by $6 billion after the $10 billion increase in income, the MPC equals 0.6. MPC = Δconsumption/Δincome = $6 billion/$10 billion = 0.6. What is the size of the multiplier? Given the MPC, we can find the multiplier, which equals 2.5. Multiplier = 1/(1 - MPC) = 1/(1 - 0.6) = 1/0.4 = 2.5. If, instead, GDP and consumption both rose by $8 billion in the second round, what would have been the size of the multiplier? If, instead, GDP and consumption rose by $8 billion after the $10 billion increase, the MPC would have been 0.8. MPC = Δconsumption/Δincome = $8 billion/$10 billion = 0.8. Given the MPC, we can find the multiplier, which equals 5. Multiplier = 1/(1 - MPC) = 1/(1 - 0.8) = 1/0.2 = 5.

Suppose a handbill publisher can buy a new duplicating machine for $500 and the duplicator has a 1-year life. The machine is expected to contribute $550 to the year's net revenue.

What is the expected rate of return? The expected rate of return equals the expected net revenue less cost divided by the cost of the machine: Expected return = (net revenue - cost)/cost = ($550 - $500)/$500 = $50/$500 = 0.1, or 10%. If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine? Yes, 10% is greater than 8% Will it invest in the machine if the real interest rate is 9 percent? Yes, 10% is greater than 9% If it is 11 percent? No, 10% is less than 11%.

What will the multiplier be given the MPC values below? Fill in the table with your answers. 0.9 =10.00 0.75 =4.00 0.5 =2.00s 0 =1.00

When the MPC is 1, the multiplier is infinity, or undefined. When the MPC is 0.9, the multiplier is 10 (= 1/(1 - 0.9) = 1/0.1). When the MPC is 0.75, the multiplier is 4.0 (= 1/(1 - 0.75) = 1/0.25. When the MPC is 0.5, the multiplier is 2.0 (= 1/(1 - 0.5) = 1/0.5). When the MPC is 0, the multiplier is 1.0 (= 1/1).

Irving owns a chain of movie theaters. He is considering whether he should build a new theater downtown. The expected rate of return is 15 percent per year. He can borrow money at a 12 percent interest rate to finance the project. Should Irving proceed with this project?

Yes, Irving should proceed with this project because the project's expected rate of return exceeds the interest rate. To see why this matters, suppose that the project will require a $10 million initial investment. Because the expected rate of return is 15 percent per year, we know that the project will return $1.5 million per year (= 15 percent × $10 million). Compare that with the annual interest payments that will be required to finance the investment. Given the interest rate of 12 percent per year, those interest payments will only be $1.2 million per year (= 12 percent × $10 million). Thus, the project's annual return of $1.5 million will exceed the project's annual interest cost of $1.2 million. That means that Irving can borrow the money and expect that his annual return of $1.5 million will be more than enough to make each year's annual interest payments of $1.2 million. In fact, he should come out ahead by $300,000 per year (= $1.5 million in annual revenue - $1.2 million in annual interest payments). Thus, Irving should proceed with this project.

The purchase of capital goods, like ____ consumer goods, can be postponed; it tends to contribute to _____ in investment spending.

durable; instability

Assume a machine that has a useful life of only one year costs $2,000. Assume, also, that net of such operating costs as power, taxes, and so forth, the additional revenue from the output of this machine is expected to be $2,300. If the firm finds it can borrow funds at an interest rate of 10 percent, the firm should

purchase the machine because the expected rate of return exceeds the interest rate.

Assume there are no investment projects in the economy that yield an expected rate of return of 25 percent or more. But suppose there are $10 billion of investment projects yielding expected returns of at least 20 percent; another $10 billion yielding at least 15 percent; another $10 billion yielding at least 10 percent; and so forth.

Draw this relationship between the expected rate of return and the amount of investment expenditure. Plot points 0,25 10,20 20,15 30,10 40,5 50,0 What will be the equilibrium level of aggregate investment if the real interest rate is as follows: 15 percent: 20 Billion 10 percent 30 billion

Which of the following would shift the consumption schedule downward?

an increase in the probability of a recession

The 45-degree line on a graph relating consumption and income shows

all the points at which consumption and income are equal.

If the MPC is 0.6, the multiplier will be

2.5

If a $50 billion initial increase in spending leads to a $250 billion change in real GDP, how big is the multiplier?

5.0: If a $50 billion initial increase in spending leads to a $250 billion change in real GDP, the multiplier is 5.0 (= $250 billion change in real GDP/$50 billion initial increase in spending).

In the accompanying graph, which of the following would shift the investment demand curve from ID2 to ID1?

increasing business taxes

The multiplier is

larger, the larger the MPC is and the smaller the MPS is. MPC + MPS = 1

Suppose the wealth effect is such that $10 changes in wealth produce $1 changes in consumption at each level of income. Assume real estate prices tumble such that wealth declines by $80. a. What will be the new level of consumption at the $340 billion level of disposable income?

If real estate prices tumble such that wealth declines by $80 and the wealth effect is such that a $10 change in wealth produces a $1 change in consumption at each level of income, then consumption will fall by $8 at every level of income (= 0.1 × $80). This implies consumption equals $316

Suppose that disposable income, consumption, and saving in some country are $200 billion, $150 billion, and $50 billion, respectively. Next, assume that disposable income increases by $20 billion, consumption rises by $18 billion, and saving goes up by $2 billion

What is the economy's MPC? Instructions: Round your answers to 1 decimal place. MPC = .9 To find the marginal propensity to consume (MPC): MPC = ΔConsumption/ΔIncome. MPC = $18/$20 = 0.9. What is its MPS? MPS =.1 To find the marginal propensity to save (MPS): MPS = ΔSaving/ΔIncome. MPS = $2/$20 = 0.1. What was the APC before the increase in disposable income? Instructions: Round your answer to 2 decimal places. APC before =.75 To find the average propensity to consume (APC) before the increase in disposable income: APC = Consumption/Income. APC = $150/$200 = 0.75. What was the APC after the increase? Instructions: Round your answer to 3 decimal places. APC after =.764 To find the APC after the increase, disposable income now equals $220 (= $200 + $20). Consumption after the change equals $168 (= $150 + $18). APC = $168/$220 = 0.764.

Refer to the given diagram. The marginal propensity to save is

CD/EF.

Expected Rate of Return (%) Amount of Investment With This Rate of Return or Higher ($B) 12% $10 10 20 8 30 6 40 4 50 2 60 The investment schedule in the given table indicates that if the real interest rate is 8 percent, then

$30 billion of investment will be undertaken.

Suppose the wealth effect is such that $10 changes in wealth produce $1 changes in consumption at each level of income. Assume real estate prices tumble such that wealth declines by $80. What will be the new level of saving?

to find the new level of saving after the decline in wealth, we subtract the new level of consumption (= $316) from disposable income (= $340), which equals $24 (= $340 - $316). Households increase saving to offset the decline in wealth.