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Chapter 22 The Short-Run Macro Model Review Questions 2. The marginal propensity to consume is (1) the slope of the consumption function; (2) the change in consumption divided by the change in disposable income; or (3) the amount by which consumption spending rises when disposable income rises by one dollar. 4. 6. 8. The two components of planned investment or investment spending are business purchases of plant and equipment and new home construction. Actual investment includes these two categories as well as changes in business inventories. If government spending increases, then firms that sell goods and services to the government will earn additional revenue, which will end up going to the factors of production that produced those goods, increasing household income. The increase in income leads households to increase spending, increasing the revenue of firms that produce consumption goods. Income increases once again, leading to a further increase in spending, and so on. In the end, GDP will rise by a multiple of the increase in government spending. An automatic stabilizer is a force that interferes with, and reduces the size of, the multiplier effect. Some automatic stabilizers for the U.S. economy include taxes, transfer payments, interest rates, prices, imports, and consumer behavior. 10. No. In the classical long-run model, fiscal policy is completely ineffective due to the crowding out effect. In the short-run macro model, however, an increase in government purchases causes a multiplied increase in equilibrium GDP. Problems and Exercises 2. a. Real GDP Autonomous Consumption MPC x Disposable Income Consumption = Autonomous Consumption + (MPC x Disposable Income) $0 $100 $200 $300 $400 $500 $600 $30 $30 $30 $30 $30 $30 $30 $0 $85 $170 $255 $340 $425 $510 $30 $115 $200 $285 $370 $455 $540 b. Real GDP Consumption Spending Planned Investment Government Spending Net Exports Aggregate Expenditures $0 $30 $40 $20 -$15 $75 $100 $200 $300 $400 $500 $600 $115 $200 $285 $370 $455 $540 $40 $40 $40 $40 $40 $40 $20 $20 $20 $20 $20 $20 -$15 -$15 -$15 -$15 -$15 -$15 $160 $245 $330 $415 $500 $585 c. d. $500 billion is the equilibrium level of real GDP. e. If the actual level of real GDP in this economy is $200 billion, then the economy will expand. This is because aggregate expenditures ($245 billion) are greater than real GDP ($200 billion), so firms find their inventories falling, and will expand output, leading to a higher real GDP in the future. f. If planned investment falls to $25 billion, the equilibrium level of real GDP will fall from $500 billion to $400 billion. 4. a. Inventories will unexpectedly fall; sending firms the signal to produce more output. GDPA is not sustainable because the extra production will move the economy to the right along the horizontal axis. b. Inventories will unexpectedly rise; sending firms the signal to produce less output. GDPB is not sustainable because cut in production will move the economy to the left along the horizontal axis. 6. a. b. c. d. Real GDP and total employment will increase. Real GDP and total employment will increase. Real GDP and total employment will decrease. Real GDP and total employment will increase. 8. a. In the table in Problem 2, the second column (C) would be affected; each number in the column would become smaller, since households would spend less at each level of income. b. The change in saving is the vertical distance between the aggregate expenditure lines. c. Real Aggregate Expenditure (C + I + NX) 1 (C + I + NX) 2 45° Y2 Y1 Real GDP 10. a. If the MPC is 0.95, then the expenditure multiplier is 20. Therefore, the change in real GDP is 20 x $7500 = $150,000. b. If the MPC is 0.65, then the expenditure multiplier is 2.86. Therefore, the change in real GDP is 2.86 x -$300 thousand = -$858 thousand. c. If the MPC is 0.75, then the expenditure multiplier is 4. Therefore, the change in real GDP is 4 x -$5 billion = -$20 billion. 12. a. The change in real GDP = (-0.75/(1 – 0.75)) x $400 thousand = -$1200 thousand. b. The change in real GDP resulting from the tax cut = (-0.60/(1-0.60)) x -$500 thousand = $750 thousand. The change in real GDP resulting from the cut in government spending = (-1/(1 – 0.60)) x -$500 thousand = -$1250 thousand. The net change in real GDP = $750 thousand + -$1250 thousand = -$500 thousand. Challenge Questions 2. Y = [a – (b T) + IP + G + NX] / (1 – b) = [1000 – (0.65 x 700) + 800 + 600 - 200] / (1 – 0.65) = 4,985.71. At this equilibrium, C = a + b(Y – T) = 1000 + 0.65(4985.71 – 700) = 3,785.71. Therefore, in equilibrium, we have aggregate expenditure = C + IP + G + NX = 3,785.71 + 800 + 600 - 200 = 4,985.71, which is equal to equilibrium real GDP. 4. No. Whenever government spending and taxes change by the same amount, real GDP changes by that same amount.