Download Extra Practice on the M, C and I KEY

Extra Practice on the M, C and I KEY
1. 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, like a rise in investment spending, has a multiplier effect on real GDP—the
only difference in this case is that real GDP falls instead of rises. The fall in 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. So consumer
spending falls as an indirect result of the fall in investment spending.
2. What is the multiplier if the marginal propensity to consume is 0.5? What is it if MPC is 0.8?
When MPC is 0.5, the multiplier is equal to 1/(1-0.5)=2. When MPC is 0.8, the multiplier is equal to 1/(1-0.8)=5.
3. Suppose a crisis in the capital markets makes consumers unable to borrow and unable to save money. What
implications 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 save or
borrow, your expected future disposable income will have no effect on your consumer spending today. In fact,
you 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.
4. For each event, explain whether the initial effect is a change in planned investment spending or a change in
unplanned inventory investment, and indicated the direction of the change.
a. An unexpected increase in consumer spending
Results in a reduction in inventories as procucers sell items from their inventories to satisfy their short-term
increase in demand. This is negative unplanned inventory investment: it reduces the value of producers’
inventories.
b. A sharp rise in the cost of business borrowing
A rise in the cost of borrowing is equivalent to a rise in the interest rate: 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.
c. A sharp increase in the economy’s growth rate of real GDP
…leads to a higher level of planned investment spending by producers as they increase production capacity
to meet higher demand.
d. An unanticipated fall in sales
…producers sell less, and their inventories grow. This leads to positive unplanned inventory investment.
5. Changes in which of the following leads to a
shift of the aggregate consumption function?
7. The slope of a family’s consumption function is
I.
Expected future disposable
equal to
income
a. The real interest rate.
II.
Aggregate wealth
b. The inflation rate.
III.
Current disposable income
c. The marginal propensity to consume.
a. I only
d. The rate of increase in household current
b. II only
disposable income.
c. III only
e. The tax rate.
d. I and II only
e. I, II, and III
8. Given the consumption function C = $16,000 +
0.5YD if individual household current disposable
6. The presence of taxes has what effect on the
income is $20,000, individual household
spending multiplier? They
consumer spending will equal
a. Increase it.
a. $36,000.
b. Decrease it.
b. $26,000.
c. Destabilize it.
c. $20,000.
d. Negate it.
d. $16,000.
e. Have no effect on it.
e. $6,000.
9. The level of planned investment spending is
negatively related to the
a. Rate of return on investment.
b. Level of consumer spending.
c. Level of actual investment spending.
d. Interest rate.
e. All of the above.
10. Actual investment spending in any period is
equal to
a. Planned investment spending + unplanned
inventory investment.
b. Planned investment spending – unplanned
inventory investment.
c. Planned investment spending + inventory
decreases.
d. Unplanned inventory investment +
inventory increases.
e. Unplanned inventory investment –
inventory increases.
11. Use the consumption function provided to answer the following questions:
C = $15,000 + 0.8YD
a. What is the value of the marginal propensity to consume? 0.8
b. If individual household current disposable income is $40,000, individual household consumer spending will
equal how much? $47,000
c. Draw a correctly labeled graph showing the consumption function.
Vertical axis labeled “Consumer Spending” and horizontal axis labeled “Current disposable income”
Vertical intercept of $15,000
Upward sloping consumption function
d. What is the slope of this consumption function? 0.8
e. On your graph from part c, show what would happen if expected future income decreased.
Consumption function shifts downwards
12. List the three most important factors affecting planned investment spending. Explain how each is related to
actual investment spending.
1. Interest Rates—the price (or opportunity cost) of investing, thus they are negatively related.
2. Expected future real GDP—if a firm expects its sales to grow rapidly in the future, it will invest in expanded
production capacity.
3. Production Capacity—if a firm finds its existing production capacity insufficient for its future production
needs, it will undertake investment spending to meet those needs.