Download Extra Practice on the Multiplier, Consumption and Investment KEY

Extra Practice on the Multiplier, Consumption and Investment KEY
1. 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.
2. 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.
3. 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 producers 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.
4. Changes in which of the following leads to a shift of the aggregate consumption function?
I.
Expected future disposable income
II.
Aggregate wealth
III.
Current disposable income
d. I and II only
a. I only
e. I, II, and III
b. II only
c. III only
5. The presence of taxes has what effect on the spending multiplier? They
d. Negate it.
a. Increase it.
e. Have no effect on it.
b. Decrease it.
c. Destabilize it.
6. The slope of a family’s consumption function is equal to
a. The real interest rate.
b. The inflation rate.
c. The marginal propensity to consume.
d. The rate of increase in household current
disposable income.
e. The tax rate.
7. 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.
8. Given the consumption function C = $16,000 + 0.5YD if individual household current disposable income is
$20,000, individual household consumer spending will equal
d. $16,000.
a. $36,000.
e. $6,000.
b. $26,000.
c. $20,000.
9. The level of planned investment spending is negatively related to the
d. Interest rate.
a. Rate of return on investment.
e. All of the above.
b. Level of consumer spending.
c. Level of actual investment spending.
10. Suppose the marginal propensity to consume is equal to 0.9 and investment spending increases by $50 billion.
Assuming no taxes and no trade, by how much will real GDP change?
a. $450 billion increase.
d. $500 billion decrease.
b. $90 billion increase.
e. $900 billion increase.
c. $500 billion increase.
11. If your disposable income increases from $10,000 to $15,000 and your consumption increases from $9,000 to
$12,000, your MPC is:
d. 0.8.
a. 0.2.
e. 0.6.
b. 0.4.
c. 0.3.
12. Suppose investment spending increases by $50 billion, and as a result the equilibrium income increases by $200
billion. The multiplier is:
d. ¼.
a. 8.
b. 10.
e. 3
c. 4.
13. 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. What will happen to the slope of the consumption function curve if the individual household decides to
increase their marginal propensity to consume?
The slope of the consumption function will become steeper.
d. What is the slope of this consumption function? 0.8
e. What would happen to levels of consumption if expected future income decreased?
Consumption function shifts downwards (decreases)
14. Explain some of the most important factors affecting planned investment spending. Explain how each is related
to actual investment spending.
a. Interest Rates—the price (or opportunity cost) of investing, thus they are negatively related.
b. Expected future real GDP—if a firm expects its sales to grow rapidly in the future, it will invest in expanded
production capacity.
c. 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.