Download EC 132 Discussion Note PS4 CHIU P.1 Disclaimer:

EC 132 Discussion Note PS4 CHIU P.1 Disclaimer: All questions are adapted directly from the textbook and problem sets. Suggestions from Professor Tresch are used in preparation of this note. All solutions are just suggestive and tentative comments, not marking criteria actually adopted, subject to further changes and interpretations. Question 1 (Q3 Ch.10 P. 269)
Answer the following questions about the cost of capital.
a) What is the cost of capital, and what are the principal components that make up the
cost of capital?
Definition: (Cost of capital) The annual cost to a firm of purchasing additional unit of
capital. (P.254)
Factor affecting cost of capital:
1) Price of capital
2) Interest rate
3) Depreciation
4) Tax policy
b) How does the U.S. Congress attempt to influence the cost of capital?
1) Corporation income tax rate
2) Depreciation allowance
3) Investment tax credit
c) Virtually all economists assume that the demand for capital (the desired stock of
capital) is closely related to the cost of capital. Why? At the same time, economists
disagree about whether investment demand is closely related to the cost of capital.
Explain why there is a difference between the demand for capital and the demand for
investment in this regard.
Net return of investment depends on cost of capital.
Difference in demand for capital and demand for investment:
1) New investment responds also to future sales, not only to cost of capital
2) Capital may not easy to substitute other factors of production
3) Tax policy would have slow effect on the investment decision
Question 2 (Q11 Ch.10 P.270)
Suppose that our simplest economy has the consumption demand and the investment
demand relationships pictured below. Show how you would combine the two
relationships to determine the equilibrium level of national income for the economy.
Also, select a level of national income different from the equilibrium level on your
diagram. Discuss how and why the economy would automatically return to the
equilibrium level of national income from the level of national income that you selected.
EC 132 Discussion Note PS4 CHIU P.2 Id Cd National Income Investment demand Consumption demand Cd Id Y National Income Y Key: Y= C+I.
Id Consumption demand/ Aggregate demand ADE,Cd Cd National Income Y Investment demand ADE = Cd + Id Id National Income Y Question 3 (Appendix Question Ch.10 P.273)
Given the following information for an economy, find the equilibrium level of national
income, YE.
Cd = 300 + 3/4Y
Id = 40
d
d
where C = consumption demand I = investment demand and Y = income (national and
disposable).
Equilibrium income: 1360
Also:
a) What is the value of the marginal propensity to consume?
MPC = 0.75
b) Find the relationship between saving demand (Sd) and national income (Y). What is the
value of the marginal propensity to save?
Since Sd = Y – Cd, so Sd = 0.25Y – 300.
Hence, MPS = 0.25.
(Note that by definition: MPC + MPS = 1)
EC 132 Discussion Note PS4 CHIU P.3 c) Show that Sd = Id at the equilibrium level of income computed above.
Given Sd = 0.25Y – 300 and Y = 1360, we have Sd = 40, done.
d) How large is aggregate demand when national income equal 1,000?
Aggregate demand (AD) = Cd + Id = 1090.
e) Describe how the economy will adjust to the equilibrium level of national income when
national income is temporarily at 1,000.
Firm would reduce its unwanted inventory or increase production to meet excess demand,
which in turn increase national income.
Question 4 (Q.4 Ch.11 P.306)
Explain why an increase in aggregate demand of $1 leads to more than a $1 increase in
the equilibrium level of national income.
Spending multiplier.
Definiton: (Spending Multiplier) The ratio relates the change in the equilibrium level
of national income to an initial change or shift in aggregate demand. (P.280)
Story: increase in aggregate demand initiate another demand which turns out to be increase in
national income.
Question 5
Using the spending multiplier to calculate the change in national income that would
result if the following two events happened simultaneously: (a) a $200 billion decrease
(shift down) in consumption demand; and (b) a $50 billion increase (shift up) in
investment demand. Assume that the MPC = 0.90.
Mspending = 1 / (1 - 0.9) = 10
(a) ΔYE = ΔC × MSpending = -200 billion ×10 = -2000 billion
(b) ΔYE = ΔGd × MSpending = 50 billion ×10 = 500 billion
Hence, overall is 1500billion