Download Using the model of supply and demand, discuss the

Economics 1221 Assignment 2 Answer Key – Summer 2012
Economics 1221 Assignment 2 – Answer Key
This has the solutions for Questions 1, 2, 4 and 6 only. The other
answers are found in the other answer key document.
Question 1:
What are the units of measure for Actual National Income and Planned Aggregate Expenditure (hint, both are
measured in the same units, you just need to determine what the units are). If this question seems easy and
straightforward, it is. I just want to send a reminder that keeping track of units is important.
The units of Actual National Income and Planned Aggregate Expenditure are both monetary units. In
Canada these things are measured in Canadian Dollars, in the U.S. they are measured in U.S. dollars, in
Japan they are measured in Yen, etc. This gets around the problem of adding things like cars and legal
services together, which have very different units, but can also be measured by their market value in
dollar terms.
Question 2:
What is the difference between autonomous and induced expenditures?
Answer:
The similarity is that they are both expenditures, which is just another term for spending.
Autonomous expenditure is spending that occurs irrespective of the level of national income (at all levels
of national income, the autonomous expenditure will be the same).
Induced expenditure is spending that depends on the level of national income. You can think of induced
meaning “caused by”. Assuming a positive relationship between induced expenditure and national
income, as the level of national income increases so will the amount of induced expenditure. In order for
induced expenditure to increase, the level on national income must increase, all else equal (the opposite is
true for induced expenditure falling).
In our model, we make some simplifying assumptions that Planned Investment Spending, a portion of
Planned Consumption Spending, Planned Export Spending, and Planned Government Spending are all
autonomous. The induced spending in the economy is a result of Planned Consumption Spending (the
portion of than autonomous Planned Consumption Spending) and Planned Import Spending. At
different levels of national income there will be different levels of induced spending.
Summing up… for all levels of national income there will be the same amount of autonomous spending.
Different levels of national income will have different levels of induced spending. Since Planned
Aggregate Expenditure is the sum of the autonomous and induced spending, different levels of national
income will have different levels of Planned Aggregate Expenditure.
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Economics 1221 Assignment 2 Answer Key – Summer 2012
Question 4:
In the Aggregate Expenditures Model developed in Chapters 21 and 22 of the text, what do the following letters
denote?
i)
ii)
iii)
iv)
v)
vi)
vii)
viii)
ix)
x)
xi)
AE – Planned Aggregate Expenditure
Y – Actual National Income (a.k.a. Real GDP)
YD – Disposable Income (equals (1-t)Y)
C – Planned Consumption Spending
I – Planned Investment Spending
G – Planned Government Spending
T – marginal propensity to tax (a.k.a. the net tax rate)
T – Net Taxes
X – Planned Export Spending
IM – Planned Import Spending (equals mY)
m – marginal propensity to import
Question 6:
Using the Aggregate Expenditures Model (under the set of assumptions outlined in class and in the text),
provide a description of the adjustment process in an economy’s Actual Level of Production (this is equivalent
to the economy’s actual national income) when the Planned Aggregate Expenditures are greater than the Actual
Level of Production.
HINT: An accurate description will include a discussion of unplanned changes in inventories and the
reaction of firms in aggregate to the “signal” they receive from changes in their inventories.
Answer:
When, in a given time period, the amount of Planned Aggregate Expenditure (AE) is greater than the
Actual Level of Production, the amount of goods and services purchased will be greater than the amount
of goods and services produced. The extra goods and services purchased beyond the current level of
production have to come from somewhere. Where they come from is the firms’ inventories, which are
made up of goods and services produced in previous time periods.
Part of planned investment spending is to maintain a certain level of inventories. When, at the end of a
given time period, the actual amount of inventories in the economy are less than what they were planned
to be, firms (in aggregate) take this situation as a signal to produce more goods and services in the next
time period (so as to restore maintain the inventories according to their plan).
As production is increased, the amount of AE will also rise (because of the induced spending portion of
AE). There is one level of Actual Production that will induce an amount of AE that is just enough to buy
up all of the goods and services that are actually produced in a given time period (that is all the spending
is planned spending, there is not any “unplanned spending”). This level of Actual Production is the
equilibrium level.
When the economy is at its equilibrium level of production, we would not expect any change to the Actual
Level of Production in the next time period.
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Economics 1221 Assignment 2 Answer Key – Summer 2012
Finally, the equilibrium Actual Level of Production can and does change in an economy. In the AE model,
the equilibrium level changes not as a result of a change in the level of Actual Production, but rather as a
result of a change in AE caused by a factor affecting AE other than the level of Actual Production. See
question 3 for a couple of examples (there are many more reasons why the AE curve would shift).
Question 7:
Assume an open-mixed economy with a marginal propensity to spend equal to 0.25 is currently in equilibrium.
Now assume there is an increase in autonomous government spending of 2 billion dollars. Under these
assumptions by how much would equilibrium income change according to the Aggregate Expenditures Model
developed in chapters 21 and 22 of the text?
Answer:
NOTE: This question does not ask what the equilibrium level is, nor is there enough information to figure
it out. It is asking about a change to the equilibrium level.
This is an application of the multiplier. Using the formula for the multiplier:
Multiplier = 1 / (1-Marginal Propensity to Spend) = 1 / (1-0.25) = 1.33
Any change to autonomous spending will result in a change to equilibrium income by 1.33 times that
change.
We are told that autonomous government spending increased by $2billion. Accounting for the multiplier
effect, the equilibrium income will rise by $2billion*1.33 = $2.66billion as a result of the new extra
spending by government.
An increase in government spending is a fiscal policy decision. A government might undertake a
spending increase to combat a recessionary gap, which is associated with high unemployment. Remember
that high unemployment has economic effects in terms of lost production (unused resources) as well as
many social problems (like increased crime, stress on families, and others).
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