Download Macroeconomics Unit 4 “Consumption, Investment, and the

Macroeconomics
Unit 4 “Consumption, Investment, and the
Multiplier”
Define the following terms:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Disposable Income (DI)
45 ₀ (degree) line
Consumption and Saving Schedules
Consumption Function
Break-even income
Autonomous Consumption
Saving Function
Dissaving
Autonomous Saving
Marginal Propensity to Consume (MPC)
Marginal Propensity to Save (MPS)
12. Determinants of Consumption and
Saving
13. Expected Real Rate of Return (r)
14. Real Rate of Interest (i)
15. Decision to Invest
16. Investment Demand
17. Autonomous Investment
18. Market for Loanable Funds
19. Demand for Loanable Funds
20. Private Saving
21. Public Saving
22. Supply of Loanable Funds
23. Multiplier Effect
24. Spending Multiplier
25. Tax Multiplier Effect
26. Balanced-Budget Multiplier
Answer the following questions as part of the portfolio:
1. Complete the following table:
a. Show the consumption and saving schedules graphically.
b. Find the break-even level of income. Explain how it is possible for households to
dissave at very low income levels.
c. If the proportion of total income consumed (APC) decreases and the proportion
saved (APS) increases as income rises, explain both verbally and graphically how
the MPC and MPS can be constant at various levels of income.
2. 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? 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? Explain.
3. 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 between 20 and 25 percent; another $10 billion yielding
between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so
forth. Cumulate these data and present them graphically, putting the expected rate of
return on the vertical axis and the amount of investment on the horizontal axis. What will
be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent,
(b) 10 percent, and (c) 5 percent? Explain why this curve is the investment demand
curve.
4. 4. What is the multiplier effect? What relationship does the MPC bear to the size of the
multiplier? The MPS? What will the multiplier be when the MPS is 0, 0 .4, 0.6, and 1?
What will it be when the MPC is 1, 0.90, 0.67, 0.50, and 0? How much of a change in
GDP will result if firms increase their level of investment by $8 billion and the MPC is
0.80? If the MPC is 0.67?
5. Suppose the government decides a tax rebate of $300 per each taxpayer. Explain the
effect of the new fiscal policy on the GDP. Use the definition of tax multiplier in your
answer.
Multiple-Choice Questions
1. If the marginal propensity to consume is 0.8, what is the largest total increase in GDP that can result
from $500 of new spending?
a) $400
b) $500
2.
3.
4.
5.
6.
7.
8.
c) $625
d) $2,500
e) $5,000
When disposable income increase by $X,
a) Consumption increases by more than $X
b) Saving increases by less than $X
c) Saving increases by exactly $X
d) Saving remains constant
e) Saving decreases by more than $X
Which of the following is true of consumption function?
a) The slope is equal to the MPC
b) The slope is equal to the MPS
c) The slope is equal to the MPC+MPS
d) It shifts upwards when consumers are more pessimistic about the future
e) It shifts downward when consumers wealth increases in value
Which of the following events most likely increases GDP?
a) An increase in the real rate of interest
b) An increase in taxes
c) A decrease in net exports
d) An increase in government spending
e) A lower value of consumer wealth
Which of the following choices is most likely to create the greatest decrease in real GDP?
a) The government decreases spending, matched with the decrease in taxes
b) The government increases spending with no increase in taxes
c) The government decreases spending with no change in taxes
d) The government holds spending constant while increasing taxes
e) The government increases spending, matched with an increase in taxes
The tax multiplier increases in magnitude when
a) The Marginal Propensity of Saving increases
b) The spending multiplier falls
c) The MPC increases
d) The government spending increases
e) Taxes increase
Which of the following is a source of the supply of loanable funds?
a) The stock market
b) Investors
c) Net exports
d) Banks and mutual funds
e) Savers
When disposable income increases by $ X,
a. Consumption increases by more than $X
b. Saving increases by more than $X
c. Saving increases by exactly $X
d. Saving remains constant
e. Saving decreases by more than $X
9. If consumption and disposable income are equal at a particular level of income:
a. the MPC must be one at this point
b. the APC must be less than one at this point
c. saving must be zero at this point
d. the MPS must be zero at this point
10. Suppose that for the entire economy, no investment projects will yield an expected real
return of more than 12%. However, $10 billion worth of projects will yield expected real
returns of 9.1% to 12%, an additional $10 billion will yield expected real returns of 6.1% to
9%, an additional $10 billion will yield expected real returns of 3.1% to 6%, and an additional
$10 billion will yield expected real returns of 0% to 3%. If the real rate of interest is 6%,
desired investment spending will be:
a. $ 0 billion
b. $10 billion
c. $20 billion
d. $30 billion
11. The investment demand curve will shift to the left if:
a. the interest rate decreases
b. the interest rate increases
c. expected returns on investment increase
d. business taxes increase
12. Use the following diagram for this question.
Which of the following might have caused the shift from consumption schedule C1 to schedule
C2?
a. An increase in disposable income
b. An increase in household wealth
c. An increase in household debt
d. An increase in taxes
13. Assume the MPC is ¾. If investment spending falls by $10 billion, the level of GDP will:
a. fall by $40 billion
b. fall by $30 billion
c. fall by $10 billion
d. fall by $7.5 billion
14. If the slope of the consumption line is 0 .8:
a. The MPC is 0.8
b. The MPS is 0.8
c. The MPC is ½
d. The MPS is ½
15. If the MPC is 0.63, the multiplier is:
a. 1/0.63
b. 1-0.37
c. 1/0.37
d. 0.63/0.37
16. If the interest rate rises:
a. planned investment spending will decrease
b. the investment demand curve will shift upward
c. the investment demand curve will shift to the left
d. the investment demand curve will shift to the right
17. The consumption schedule is:
a. An inverse relationship between consumption and the price level.
b. A direct relationship between consumption and disposable income
c. An inverse relationship between consumption and saving
d. An inverse relationship between consumption and the tax rate
18. Along a particular saving schedule, each change in disposable income of $15 billion
generates an additional $3 billion in saving. Therefore:
a. The MPS is 0.3
b. The MPS is 0.2
c. The APC is 0.8
d. The slope of the consumption schedule is 0.7
Answer Key:
(Key Question) Complete the accompanying table.
Level of Output
and income
(GDP = DI) Consumption
$240
260
280
300
320
340
360
380
400
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
Saving
APC
APS
MPC
MPS
$-4
0
4
8
12
16
20
24
28
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
Data for completing the table (top to bottom). Consumption: $244; $260; $276; $292; $308; $324; $340;
$356; $372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .00; .01; .03; .04; .05;
.06; .06; .07. MPC: .80 throughout. MPS: .20 throughout.
a. Show the consumption and saving schedules graphically.
b. Find the break-even level of income. Explain how is it possible for households to dissave at
very low income levels.
c. If the proportion of total income consumed (APC) decreases and the proportion saved (APS)
increases as income rises, explain both verbally and graphically how the MPC and MPS can
be constant at various levels of income.
(a) See the graphs.
(b) Break-even income = $260. Households dissave borrowing or using past savings.
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(c) Technically, the APC diminishes and the APS increases because the consumption and saving
schedules have positive and negative vertical intercepts respectively. (Appendix to Chapter
1). MPC and MPS measure changes in consumption and saving as income changes; they are
the slopes of the consumption and saving schedules. For straight-line consumption and
saving schedules, these slopes do not change as the level of income changes; the slopes and
thus the MPC and MPS remain constant.
(Key Question) 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? 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? Explain.
The expected rate of return is 10% ($50 expected profit/$500 cost of machine). The $50 expected
profit comes from the net revenue of $550 less the $500 cost of the machine.
If the real interest rate is 8%, the publisher will invest in the machine as the expected profit
(marginal benefit) from the investment exceeds the cost of borrowing the funds (marginal cost).
(Key Question) Assume there are no investment projects in the economy which yield an expected
rate of return of 25 percent or more. But suppose there are $10 billion of investment projects
yielding expected rate of return of between 20 and 25 percent; another $10 billion yielding
between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth.
Cumulate these data and present them graphically, putting the expected rate of net return on the
vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium
level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5
percent? Explain why this curve is the investment-demand curve.
See the graph below. Aggregate investment: (a) $20 billion; (b) $30 billion; (c) $40 billion. This
is the investment-demand curve because we have applied the rule of undertaking all investment
up to the point where the expected rate of return, r, equals the interest rate, i.
(Key Question) What is the multiplier effect? What relationship does the MPC bear to the size of
the multiplier? The MPS? What will the multiplier be when the MPS is 0, .4, .6, and 1? What
will it be when the MPC is 1, .9, .67, .5, and 0? How much of a change in GDP will result if
firms increase their level of investment by $8 billion and the MPC is .80? If the MPC is .67?
The multiplier effect describes how an initial change in spending ripples through the economy to
generate a larger change in real GDP. It occurs because of the interconnectedness of the
economy, where a change in Lasslett’s spending will generate more income for Gavidia, who will
in turn spend more, generating additional income for Grimes.
The MPC is directly (positively) related to the size of the multiplier. The MPS is inversely
(negatively) related to the size of the multiplier.
The multiplier values for the MPS values: undefined, 2.5, 1.67, 1.
The multiplier values for the MPC values: undefined, 10, 3 (approx. actually 3.03), 2, 0.
If MPC is .80, change in GDP is $40 billion (5 x $8 = $40)
If MPC is .67, change in GDP is $24 billion (approximately) (3 x $8 = $24)