Macroeconomics, 8e (Abel/Bernanke/Croushore)
Chapter 4 Consumption, Saving, and Investment
4.1 Consumption and Saving
1) Desired national saving equals
A) Y – – G.
B) + + G.
C) + G.
D) Y – – G.
2) With no inflation and a nominal interest rate (i) of .03, a person can trade off one unit of
current consumption for ________ units of future consumption.
A) 0.97
B) 1.03
C) .03
D) -.03
3) The desire to have a relatively even pattern of consumption over time is known as
A) excess sensitivity.
B) the substitution effect.
C) the consumption-smoothing motive.
D) forced saving.
4) When a person gets an increase in current income, what is likely to happen to consumption
and saving?
A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.
5) Last year, Linus earned a salary of $25,000 and he spent $24,000, thus saving $1,000. At the
end of the year, he received a bonus of $1,000 and he spent $500 of it, saving the other $500.
What was his marginal propensity to consume?
A) .96
B) .50
C) .04
D) .02
6) The fraction of additional current income that a person consumes in the current period is
known as the
A) consumption-smoothing motive.
B) consumption deficit.
C) saving rate.
D) marginal propensity to consume.
7) An increase in expected future output while holding today’s output constant would
A) increase today’s desired consumption and increase desired national saving.
B) increase today’s desired consumption and decrease desired national saving.
C) decrease today’s desired consumption and increase desired national saving.
D) decrease today’s desired consumption and decrease desired national saving.
8) When a person receives an increase in wealth, what is likely to happen to consumption and
saving?
A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.
9) Aunt Agatha has just left her nephew $5000. The most likely response is for her nephew to
A) increase current consumption, but not future consumption.
B) decrease current consumption, but increase future consumption.
C) increase future consumption, but not current consumption.
D) increase both current consumption and future consumption.
10) The stock market just crashed; the Dow Jones Industrial Average fell by 750 points. You
would expect the effect on aggregate consumption to be the largest if which of the following
facts was true?
A) The crash had been preceded by a large run-up in the price of stocks.
B) Most stocks were owned by insurance companies.
C) Most stocks were owned by pension funds that invested in the market.
D) Many individuals had invested in the stock market immediately prior to the crash.
11) An increase in the personal income tax rate on interest income will
A) increase desired saving because the expected after-tax real interest rate rises.
B) decrease desired saving because the expected after-tax real interest rate rises.
C) decrease desired saving because the expected after-tax real interest rate falls.
D) increase desired saving because the expected after-tax real interest rate falls.
12) If the substitution effect of the real interest rate on saving is larger than the income effect of
the real interest rate on saving, then a rise in the real interest rate leads to a ________ in
consumption and a ________ in saving, for someone who’s a lender.
A) fall; fall
B) fall; rise
C) rise; rise
D) rise; fall
13) If the substitution effect of the real interest rate on saving is smaller than the income effect of
the real interest rate on saving, then a rise in the real interest rate leads to a ________ in
consumption and a ________ in saving, for someone who’s a lender.
A) fall; fall
B) fall; rise
C) rise; rise
D) rise; fall
14) With a nominal interest rate of 4%, an expected inflation rate of 1%, and interest income
taxed at a rate of 25%, what is the expected after-tax real interest rate?
A) 3%
B) 2%
C) 1%
D) 0%
15) The nominal interest rate is 10%, the expected inflation rate is 5%, and the combined state-
federal tax rate is 35%. The expected after-tax real interest rate is
A) 1.50%.
B) 3.25%.
C) 5.00%.
D) 6.50%.
16) Three factors that cause interest rates among different financial instruments to vary are
A) default risk, expected inflation, and taxability.
B) default risk, current inflation, and taxability.
C) default risk, maturity, and taxability.
D) default risk, expected inflation, and maturity.
17) The yield curve generally slopes upward because
A) longer maturity bonds typically pay higher interest rates than shorter maturity bonds.
B) longer maturity bonds typically pay lower interest rates than shorter maturity bonds.
C) shorter maturity bonds have more default risk.
D) longer maturity bonds are not taxable.
18) If an investor has a tax rate on interest income of 25% and the inflation rate is 4%, which
bond has the lowest expected after-tax real interest rate?
A) A Treasury bond paying 9%
B) A corporate bond paying 8%
C) A Treasury bond paying 7%
D) A municipal bond paying 6%
19) If an investor has a tax rate on interest income of 30% and the inflation rate is 4%, which
bond has the highest expected after-tax real interest rate?
A) A Treasury bond paying 8%
B) A corporate bond paying 7%
C) A Treasury bond paying 7%
D) A municipal bond paying 6%
20) The yield curve shows
A) the yields on stocks of different maturities.
B) the interest rates on bonds of different maturities.
C) the yields on stocks with differing default risk.
D) the yields on bonds with differing default risk.
21) Desired national saving would increase unambiguously if there were
A) an increase in both current output and expected future output.
B) an increase in both expected future output and government purchases.
C) an increase in both expected future output and the expected real interest rate.
D) a fall in both government purchases and expected future output.
22) Desired national saving would decrease unambiguously if there were
A) a decrease in current output and a decrease in taxes.
B) an increase in expected future output and a decrease in government purchases.
C) an increase in both expected future output and the expected real interest rate.
D) a fall in both government purchases and expected future output.
23) The Ricardian equivalence proposition suggests that a government deficit caused by a tax cut
A) causes inflation.
B) causes a current account deficit.
C) raises interest rates.
D) doesn’t affect consumption.
24) If the government cuts taxes today, issuing debt today and repaying the debt plus interest
next year, a rational taxpayer will
A) spend the full amount of the tax cut today and reduce consumption next year.
B) increase consumption today, before taxes go up next year.
C) increase saving today, leaving consumption unchanged.
D) leave a smaller gross bequest to her or his heirs.
25) Which of the factors listed below might cause the Ricardian equivalence proposition to be
violated?
A) There may be international capital inflows and outflows.
B) Consumers may not understand that an increase in government borrowing today is likely to
lead to higher future taxes.
C) There may be constraints on the level of government spending.
D) There may be constraints on the level of government taxation.
26) What is the marginal propensity to consume, and why is it always less than one?
27) How would the expected real after-tax rate of return be affected by each of the following
events?
(1) the tax rate on interest income increases
(2) expected inflation declines
28) Sally will earn $30,000 this year and $40,000 next year. The real interest rate is 20%
between this year and next year; she can borrow or lend at this rate. She has no wealth at the start
of this year and plans to finish next year having consumed everything she possibly can. She
would like to consume the same amount this year as next year. The inflation rate is 0%.
(a) How much should Sally save this year? How much will Sally consume in each of the two
years?
(c) How would your answers change if the real interest rate was 40%?
29) Jane wants to save $1000 of current income. With an IRA, no taxes are paid on income or
interest until the money is withdrawn in five years. Without an IRA, taxes must be paid
whenever income or interest is received. Jane‘s federal/state tax bracket is 35%, and the nominal
interest rate is 8%.
(a) How much money will Jane have if she puts her money in an IRA and withdraws the money
in five years?
(b) How much money will Jane have if she does NOT put her money in an IRA, but rather in a
regular (taxable) savings account, for five years?
(c) How much does Jane gain in five years by using an IRA rather than a regular savings
account?
30) Suppose the one-year T-bill rate was 5% on 1/1/2007, 4% on 1/1/2008, and 6% on 1/1/2009.
The GDP deflator (2004 = 100) was 110 on 1/1/2007, 112 on 1/1/2008, 114 on 1/1/2009, and
120 on 1/1/2010. The tax rate on interest income is 30%.
(a) Calculate the after-tax nominal rate of return for 2007, 2008, and 2009.
(b) If you began with $1000 on 1/1/2007 and invested in T-bills each year (paying taxes at the
end of each year), how much would you have in nominal terms on 1/1/2010? How much would
you have in real terms (2004 dollars)?
(c) How much was your nominal after-tax interest earned in part (b) over the three years? How
much did you earn in real (2004) after-tax dollars?
31) Suppose the nominal interest rate is 6%, the tax rate on interest income is 30%, and expected
inflation is 3%.
(a) Calculate the expected after-tax real interest rate.
(b) Calculate the expected after-tax real interest rate if the nominal interest rate falls to 4%.
(c) Calculate the expected after-tax real interest rate if the tax rate increases to 50% (with the
nominal interest rate at its original value of 6%).
(d) Calculate the expected after-tax real interest rate if expected inflation increases to 5% (with
the nominal interest rate at its original value of 6% and the tax rate at its original value of 30%).
32) The nominal interest rate on taxable bonds is 8%, while on municipal bonds (which aren’t
taxable) it is 5%. The expected inflation rate is 3% and the tax rate on interest income is 40%.
Calculate the expected after-tax real interest rate on both bonds. Which would be the better
investment? Now suppose the actual inflation rate turned out to be 6%. Which bond was the
better investment? Would your answer change if inflation had turned out to be 0%?
33) Suppose you divide your life into two periods-working age and retirement age. When you
work, you earn labor income Y; when retired, you earn no labor income, but must live off your
savings and the interest it earns. You save the amount S while working, earning interest at rate r,
so you have (1 + r)S to live on when retired. Because you don’t need to consume as much when
retired, you want to set consumption when working twice as high as consumption when retired.
(a) Suppose you earn $1 million over your working life, and the real interest rate for retirement
saving is 50%. How much will you save and how much will you consume in each part of your
life?
(b) Suppose your current income went up to $2 million when working. Now what will you save
and how much will you consume each period?
(c) Suppose a social security system will pay you 25% of your working income when you are
retired. Now (with Y = $1 million, as in part (a) how much will you save and how much will you
consume each period?
(d) Suppose the interest rate rises (starting from the situation in part (a). Will you save more or
less?
34) In 1991 the federal government changed the withholding amounts for personal taxes. The
change meant that people wouldn’t have as much withheld from their paychecks. But there was
no change in the tax code itself, so the amount of tax due in April 1992 was not changed. How
would consumption and saving respond to this withholding change? (Note: you may assume a
real interest rate of 0%.)
4.2 Investment
1) The user cost of capital is given by the following formula, where is the real price of capital
goods, d is the depreciation rate, and r is the expected real interest rate.
A) uc = (r + d)/
B) uc = /(r + d)
C) uc = d /r
D) uc = (r + d)
2) Which of the following machines has the lowest user cost? Machine A costs $15,000 and
depreciates at a 25% rate, machine B costs $10,000 and depreciates at a rate of 20%, machine C
costs $20,000 and depreciates at a rate of 10%, and machine D costs $17,000 and depreciates at a
rate of 11%. The expected real interest rate is 5%.
A) Machine A
B) Machine B
C) Machine C
D) Machine D
3) Which of the following machines has the lowest user cost? Machine A costs $15,000 and
depreciates at a rate of 25%, machine B costs $10,000 and depreciates at a rate of 20%, machine
C costs $20,000 and depreciates at a rate of 10%, and machine D costs $17,000 and depreciates
at a rate of 11%. The expected real interest rate is 0%.
A) Machine A
B) Machine B
C) Machine C
D) Machine D
4) Calculate the user cost of capital of a machine that costs $5,000 and depreciates at a rate of
25%, when the expected real interest rate is 5%.
A) $150
B) $500
C) $1500
D) $5000
5) Calculate the user cost of capital of a machine that costs $5,000 and depreciates at a rate of
25%, when the nominal interest rate is 10% and the expected inflation rate is 5%.
A) $150
B) $500
C) $1500
D) $5000
6) Calculate the user cost of capital of a machine that costs $100,000 and depreciates at a rate of
25%, when the nominal interest rate is 4% and the expected inflation rate is 1%.
A) $3,000
B) $25,000
C) $28,000
D) $29,000
7) Calculate the user cost of capital of a machine that costs $5,000 and depreciates at a 25% rate,
when the nominal interest rate is 5% and the expected inflation rate is 10%.
A) $5,000
B) $1500
C) $1000
D) $100
8) You are trying to figure out how much capacity to add to your factory. You will increase
capacity as long as
A) the expected marginal product of capital is positive.
B) the expected marginal product of capital is greater than or equal to the marginal product of
capital.
C) the expected marginal product of capital is greater than or equal to the expected marginal
product of labor.
D) the expected marginal product of capital is greater than or equal to the user cost of capital.
9) When a company must consider taxes in determining investment, its desired capital stock is
chosen such that
A) MPKf = uc(1-t)
B) MPKf = uc/(1-t)
C) MPKf = t × uc
D) t × MPKf = uc
10) The desired level of the capital stock will increase if the
A) user cost of capital increases.
B) expected future marginal product of capital increases.
C) effective tax rate increases.
D) price of capital increases.
11) An increase in the expected real interest rate will
A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as a decrease in corporate taxes.
12) If the rate of depreciation increases, then user cost ________ and the desired capital stock
________.
A) falls; falls
B) falls; rises
C) rises; rises
D) rises; falls
13) The relationship between stock prices and firms’ investments in physical capital is captured
by what theory?
A) User-cost-of-capital theory
B) q theory
C) Yield-curve theory
D) Keynesian theory
14) Tobin’s q is equal to
A) the ratio of capital’s market value to its replacement cost.
B) the ratio of capital’s replacement cost to its market value.
C) the expected after-tax real interest rate.
D) the stock market value of a firm.
15) If the stock market value of a firm is $10 million and the firm owns $15 million of capital,
then Tobin’s q equals
A) 2/3.
B) 1.
C) 3/2.
D) 4.
16) A firm should invest more if Tobin’s q
A) equals zero.
B) is less than one.
C) equals one.
D) is more than one.
17) A technological improvement will
A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as an increase in corporate taxes.
18) Suppose your company is in equilibrium, with its capital stock at its desired level. A
permanent decline in the expected real interest rate now has what effect on your desired capital
stock?
A) Raises it, because the future marginal productivity of capital is higher
B) Lowers it, because the future marginal productivity of capital is lower
C) Raises it, because the user cost of capital is now lower
D) Lowers it, because the user cost of capital is now higher