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ECON 2020—Macroeconomics
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Assignment Designation:
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Question 1: Assuming the level of investment is $16 billion and independent of the level of total
output, complete the following table and determine the equilibrium levels of output and employment
in this private closed economy. What are the sizes of the MPC and MPS?
Possible levels
of employment
(millions)
Real domestic
output (GDP=DI)
(billions)
Consumption
(billions)
Saving
(billions)
40
45
50
55
60
65
70
75
80
$240
260
280
300
320
340
360
380
400
$244
260
276
292
308
324
340
356
372
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
$ _____
Answer: Saving data for completing the table (top to bottom): $-4; $0; $4; $8; $12; $16; $20;
$24; $28.
Equilibrium GDP = $340 billion, determined where (1) aggregate expenditures equal
GDP (C of $324 billion + I of $16 billion = GDP of $340 billion); or (2) where planned I = S (I of
$16 billion = S of $16 billion). Equilibrium level of employment = 65 million; MPC = .8; MPS =
.2.
Question 2: Why is saving called a leakage? Why is planned investment called an injection?
Why must saving equal planned investment at equilibrium GDP in the private closed economy?
Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain.
Answer: Saving is like a leakage from the flow of aggregate consumption expenditures because
saving represents income not spent. Planned investment is an injection because it is spending on
capital goods that businesses plan to make regardless of their current level of income. If the two
are unequal, there will be a discrepancy between spending and production that will result in
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ECON 2020—Macroeconomics
unplanned inventory changes. Firms, not wanting inventory levels to change, will change
production, implying that equilibrium can only occur when the saving leakage equals the
injection of investment spending in a private closed economy.
At equilibrium GDP there will be no changes in unplanned inventories because expenditures will
exactly equal planned output levels which include consumer goods and services and planned
investment. Thus there is no unplanned investment including no unplanned inventory changes.
Question 3: Why is the long-run aggregate supply curve vertical? Explain the shape of the shortrun aggregate supply curve. Why is the short-run curve relatively flat to the left of the full
employment output and relatively steep to the right?
Answer: The long-run aggregate supply curve is vertical (at the full-employment or potential
output) because the economy’s potential output is determined by the availability and productivity
of real resources, not by the price level. The availability and productivity of real resources is
reflected in the prices of inputs, and in the long run these input prices (including wages) adjust to
match changes in the price level. Firms have no incentive to increase production to take
advantage of higher prices if they simultaneously face equally higher resource prices.
The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more
slowly than the price level, leaving room for firms to take advantage of these higher prices
(temporarily) by increasing output. Firms face increasing per unit production costs as they
increase output, making higher prices necessary to induce them to produce more.
To the left of full-employment output the curve is relatively flat because of the large amounts of
unused capacity and idle human resources. Under such conditions, per-unit production costs rise
slowly because of the relative abundance of available inputs. Additional resources are easily
brought into production, as the suppliers of these resources (especially labor) are anxious to
employ them and are happy to accept current prices.
To the right of full-employment output the curve is relatively steep because most resources are
already employed. Those resources that are not yet in production require higher prices to induce
them, or generate higher per-unit production costs because they are less productive than currently
employed inputs. Firms trying to increase production bid up input prices as they attempt to
attract resources away from other firms. Even if the firm succeeds in pulling resources from
another firm, the aggregate increase in output is minimal at best, as resources are merely shifted
from one productive process to another.
Question 4: Distinguish between “real-balances effect” and “wealth effect,” as the terms are
used in this chapter. How does each relate to the aggregate demand curve?
Answer: The “real balances effect” refers to the impact of price level on the purchasing power of
asset balances. If prices decline, the purchasing power of assets will rise, so spending at each
income level should rise because people’s assets are more valuable. The reverse outcome would
occur at higher price levels. The “real balances effect” is one explanation of the inverse
relationship between price level and quantity of expenditures.
The “wealth effect” assumes the price level is constant, but a change in consumer wealth causes a
shift in consumer spending; the aggregate expenditures curve will shift right. For example, the
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ECON 2020—Macroeconomics
value of stock market shares may rise and cause people to feel wealthier and spend more. A
stock decline can cause a decline in consumer spending.
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