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Chapter 10 - Basic Macroeconomic Relationships
Chapter 10 - Basic Macroeconomic Relationships
McConnell Brue Flynn 20e
DISCUSSION QUESTIONS
1. Precisely how do the MPC and the APC differ? How does the MPC differ from the MPS? Why
must the sum of MPC and the MPS equal 1? LO1
Answer: MPC refers to changes in spending and income at the margin. Here we
When your income changes there are only two possible options regarding what to
2. Why does a downshift of the consumption schedule typically involve an equal upshift of the
saving schedule? What is the exception to this relationship? LO2
Answer: If, by definition, all that you can do with your income is use it for
The exception is a change in personal taxes. When these change, your disposable
3. Why will a reduction in the real interest rate increase investment spending, other things equal?
LO3
Answer: Firms will only make an investment purchase if the expected return is greater
than or equal to real interest rate at which it can borrow.
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Chapter 10 - Basic Macroeconomic Relationships
However, if you can earn a rate of return of 5% on the borrowed $100, then you will have
Using this logic, a reduction in the real interest rate will make previously unprofitable
4. In what direction will each of the following occurrences shift the investment demand curve,
other things equal? LO4
a. An increase in unused production capacity occurs.
b. Business taxes decline.
c. The costs of acquiring equipment fall.
d. Widespread pessimism arises about future business conditions and sales revenues.
e. A major new technological breakthrough creates prospects for a wide range of profitable new
products.
Answer: a. This will decrease investment demand causing the investment curve to shift
b. This will increase investment demand causing the investment curve to shift to the right.
c. This will increase investment demand causing the investment curve to shift to the right.
d. This will decrease investment demand causing the investment curve to shift to the left.
e. This will increase investment demand causing the investment curve to shift to the right.
5. How is it possible for investment spending to increase even in a period in which the real
interest rate rises? LO4
Answer: As long as expected rates of return rise faster than real interest rates,
6. Why is investment spending unstable? LO4
Answer: Investment is unstable because, unlike most consumption, it can be put
off. In good times, with demand strong and rising, businesses will bring in more
Also, new business ideas and the innovations that spring from them do not come
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Chapter 10 - Basic Macroeconomic Relationships
7. Is the relationship between changes in spending and changes in real GDP in the multiplier
effect a direct (positive) relationship or is it an inverse (negative) relationship? How does the size
of the multiplier relate to the size of the MPC? The MPS? What is the logic of the multiplier-
MPC relationship? LO5
Answer: The key relationship is as follows:
Change in Real GDP = multiplier x change in spending
From this equation we can see that there is direct relationship between changes in
spending and changes in real GDP. When spending increases real GDP increases and
when spending decreases real GDP decreases. They both move in the same direction.
To answer the next part of the question we use the following relationships.
MPC + MPS = 1
and
From above, we see that an increase in the MPC increases the multiplier and a decrease
in the MPC reduces the multiplier. For the MPS, we see that an increase in the MPS
8. Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter’s
example? LO5
Answer: The actual multiplier (estimated to be about 2) is smaller because it
9. LAST WORD What is the central economic idea humorously illustrated in Art Buchwald’s
piece, “Squaring the Economic Circle”? How does the central idea relate to economic recessions,
on the one hand, and vigorous economic expansions, on the other?
Answer: The central idea illustrated is the multiplier effect that exists in a market
economic system. One independently determined change in spending has an effect
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Chapter 10 - Basic Macroeconomic Relationships
The multiplier effect helps us understand why there is a business cycle as opposed
to a stable level of output growth from year to year. In the Buchwald piece, a
“downturn” for one person became a downturn for everyone in that fictional
economy. Likewise, if the story had begun with a burst of optimism and an
increase in spending, it might have rippled through to expand everyone’s fortunes.
The multiplier intensifies the effect of a spending change, whether it is an increase
or decrease.
REVIEW QUESTIONS
1. What are the variables (the items measured on the axes) in a graph of the (a) consumption
schedule and (b) saving schedule? Are the variables inversely (negatively) related or are they
directly (positively) related? What is the fundamental reason that the levels of consumption and
saving in the United States are each higher today than they were a decade ago? LO1
Answer: (a) Consumption schedule: The variable on the vertical axis (y-axis) is
These variables are directly (positively) related because they move in the same direction.
(b) Saving schedule: The variable on the vertical axis (y-axis) is saving and the variable
2. In year one, Adam earns $1,000 and saves $100. In year 2, Adam gets a $500 raise so that he
earns a total of $1,500. Out of that $1,500, he saves $200. What is Adam’s MPC out of his $500
raise? LO1
a. 0.50.
b. 0.75.
c. 0.80.
d. 1.00.
Answer: c. 0.80.
Adam’s MPC out of his $500 raise is 0.80. That is true because when Adam’s income
MPC = (change in consumption) / (change in income)
Substituting Adam’s values into the formula tells us that MPC = 0.80 (= $400/$500). If
Looking at those two consumption numbers, we see that Adam’s consumption rises from
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Chapter 10 - Basic Macroeconomic Relationships
3. If the MPS rises, then the MPC will: LO1
a. Fall.
b. Rise.
c. Stay the same.
If the MPS rises, then the MPC will fall.
That has to happen because MPS + MPC = 1. Thus, if the MPS rises, the MPC must fall
by an equal amount (so that their sum still equals 1).
4. In what direction will each of the following occurrences shift the consumption and saving
schedules, other things equal? LO2
a. A large decrease in real estate values, including private homes.
b. A sharp, sustained increase in stock prices.
c. A 5-year increase in the minimum age for collecting Social Security benefits.
d. An economy-wide expectation that a recession is over and that a robust expansion will occur.
e. A substantial increase in household borrowing to finance auto purchases.
Answer: a. The consumption schedule will shift downward and the saving schedule will
b. The consumption schedule will shift upward and the saving schedule will shift
c. The consumption schedule will likely shift upward and the saving schedule will likely
d. The consumption schedule will shift upward and the saving schedule will shift
e. The consumption schedule will shift upward and the saving schedule will shift
5. Irving owns a chain of movie theaters. He is considering whether he should build a new theater
downtown. The expected rate of return is 15 percent per year. He can borrow money at a 12
percent interest rate to finance the project. Should Irving proceed with this project? LO3
a. Yes.
b. No.
Irving should proceed with this project because the project’s expected rate of return
exceeds the interest rate. To see why this matters, suppose that the project will require a
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Chapter 10 - Basic Macroeconomic Relationships
Please note, however, that investments are risky and that Irving will also take into
The investment demand curve will shift right in only two of the scenarios: the expected
return on capital increases and firms are planning on increasing their inventories. Let’s go
7. True or False: Real GDP is more volatile (variable) than gross investment. LO4
8. If a $50 billion initial increase in spending leads to a $250 billion change in real GDP, how big
is the multiplier? LO5
a. 1.0.
b. 2.5.
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Chapter 10 - Basic Macroeconomic Relationships
c. 4.0.
d. 5.0.
Answer: 5.0: If a $50 billion initial increase in spending leads to a $250 billion change in
9. True or False. Larger MPCs imply larger multipliers. LO5
Answer: True: This statement is true because larger MPCs do imply larger multipliers.
The intuition is that with a larger MPC, you will see larger amounts of consumption in
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