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Macro – Unit 3 – Short Answer Essay Practice Questions 3. Some economists claim that investment spending is more important than consumption spending in causing changes in the business cycle. However, investment spending is only one-fourth of consumption spending. Explain why investment spending can be so important if it is so much less than consumption spending. Decisions regarding investment spending are a marginal cost-marginal benefit analysis. The benefit is the expected rate of return from the planned investment in capital and the cost is the rate of interest to borrow or lose from using saved funds. Investment spending is the unstable component of aggregate demand. Investment does not closely follow GDP, yet investment in capital goods provides the seeds of productivity gains, the implementation of technological advances and future increases in output. New investment increases the longrun aggregate supply curve and allows for more capacity. 1 4. In 1981, factories used 79 percent of their capacity. In 1982, factories used 71 percent of their capacity. In which year do you think the economy was on a steeper portion of its short-run aggregate supply curve? Explain. The economy would be on the steeper part of the aggregate-supply curve in 1981 at a 79 percent capacity utilization rate. The economy would be approaching the potential level of output. In 1982, with a 71 percent capacity utilization rate, the economy would be further away from potential GDP. In addition, the price level was probably rising faster in 1981 than in 1982 because as the economy nears full-employment (potential GDP), pressure on prices increases. A typical short-run aggregate supply curve Price level AS AD4 O Y1 Y2 AD3 AD2 AD1 Y3 Y4 YP National output 2 6. A town’s largest industry invests $50 million to expand its plant capacity. Without using a formula, explain how this expenditure will affect the town’s economy through the multiplier effect. Suppose that the plant expansion takes the form of adding a new building. Local construction firms will supply the labor for the construction and hence their incomes increase as do the number of laborers hired to build the new plant. In turn these people spend part of their new income in town to buy food and other consumer products. The incomes of stores increase and store owners in turn spend a proportion of their income and the process continues multiplying the initial $50 million expenditure. 3 7. Throughout most of the decade of the 1990’s, gains were made in productivity. What effect do these yearly gains have on the short-run aggregate supply curve? Is there any change in long-run aggregate supply? Gains in productivity shift the short-run aggregate supply curve to the right. In turn, the long-run aggregate supply curve also shifts to the right. 4