978-1259723223 Chapter 30

Chapter 30 – Basic Macroeconomic Relationships

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Chapter 30 – Basic Macroeconomic Relationships

McConnell Brue Flynn 21e

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

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

3. Why will a reduction in the real interest rate increase investment spending, other things equal?

LO3

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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.

The logic is as follows. If you borrow a $100 at an interest rate of 10%, then at the end of

the year you will owe $110.

Now, if you can earn a rate of return of 20% on the borrowed $100, then you will have

$120 from your investment at the end of the year. You pay off the $110 loan and keep

$10. This is a good investment.

However, if you can earn a rate of return of 5% on the borrowed $100, then you will have

$105 from your investment at the end of the year. You pay off the $110 loan and lose $5.

This is a bad investment.

Using this logic, a reduction in the real interest rate will make previously unprofitable

investments profitable. Thus, other things equal, this will increase investment.

For example, if the real interest rate fell from 10% to 3% it would be a good investment

to borrow at 5% and now, where it wasn‘t before when the real interest rate was 10%.

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.

5. How is it possible for investment spending to increase even in a period in which the real

interest rate rises? LO4

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6. Why is investment spending unstable? LO4

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

8. Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter’s

example? LO5

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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?

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

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.

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Answer: c. 0.80.

Adam’s MPC out of his $500 raise is 0.80. That is true because when Adam’s income

goes up by a marginal (extra) $500, his consumption goes up by a marginal (extra) $400.

Those numbers allow us to calculate the MPC as:

MPC = (change in consumption) / (change in income)

Substituting Adam’s values into the formula tells us that MPC = 0.80 (= $400/$500). If

you are confused about Adam’s marginal consumption going up by exactly $400, think

about how much he was consuming in each year. To do so, remember that any money

that is not saved is by definition consumed. So when Adam saves $100 in year 1 out of an

income of $1,000, he must be consuming $900 (= $1,000 – $100) that year. In the same

way, when he is saving $200 out of an income of $1,500 in year 2, he must be consuming

$1,300 (= $1,500 – $200).

Looking at those two consumption numbers, we see that Adam’s consumption rises from

$900 in year 1 to $1,300 in year 2, which is a $400 increase. And because that $400

increase came in response to a $500 increase in pay, we know that his MPC out of that

$500 increase in pay is 0.80.

3. If the MPS rises, then the MPC will: LO1

a. Fall.

b. Rise.

c. Stay the same.

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.

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Answer: a. The consumption schedule will shift downward and the saving schedule will

shift upward given the decrease in wealth.

b. The consumption schedule will shift upward and the saving schedule will shift

downward given the increase in wealth.

c. The consumption schedule will likely shift upward and the saving schedule will likely

shift downward given that individuals will need to work 5 more years before retiring.

There is less need to save for retirement.

d. The consumption schedule will shift upward and the saving schedule will shift

downward because individuals expect to be earning higher income in the future.

e. The consumption schedule will shift upward and the saving schedule will shift

downward as individuals borrow (decrease saving) and purchase the automobiles

(increase consumption).

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.

6. Which of the following scenarios will shift the investment demand curve right? LO4

a. Business taxes increase.

b. The expected return on capital increases.

c. Firms have a lot of unused production capacity.

d. Firms are planning on increasing their inventories.

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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.

c. 4.0.

d. 5.0.

9. True or False. Larger MPCs imply larger multipliers. LO5

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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

each round of the multiplier process. To see why, consider two different MPCs, 0.5 and

0.9. If there is an initial $1 increase in spending in the economy and the MPC is only 0.5,

the first three rounds of the multiplier process will be $1.00, $0.50, and $0.25. By

comparison, if the MPC is 0.9, the first three rounds of the multiplier process will be

$1.00, $0.90, and $0.81. What we see is that starting with the second round, the numbers

are much larger when the MPC is 0.9. As a result, the total cumulative change in GDP

over all rounds of the multiplier process is also going to be much larger when the MPC is

0.9. Generalizing from this specific example, we see that higher MPCs imply higher

multipliers.

PROBLEMS

1. Refer to the incomplete table below. LO1

a. Fill in the missing numbers in the table.

b. What is the break-even level of income in the table? What is the term that economists use for

the saving situation shown at the $240 level of income?

c. For each of the following items indicate whether the value in the table is either constant or

variable as income changes: the MPS, the APC, the MPC, the APS.

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Feedback: Part a:

Level of

Output

and

Income

(GDP=DI)

Consumption

Saving

APC

APS

MPC

MPS

$240

$244

–$4

1.0167

-0.0167

0.8

0.2

260

$260

0

1

0

0.8

0.2

280

$276

4

0.9857

0.0143

0.8

0.2

300

$292

8

0.9733

0.0267

0.8

0.2

320

$308

12

0.9625

0.0375

0.8

0.2

340

$324

16

0.9529

0.0471

0.8

0.2

360

$340

20

0.9444

0.0556

0.8

0.2

380

$356

24

0.9368

0.0632

0.8

0.2

400

$372

28

0.93

0.07

0.8

0.2

Part b:

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2. Suppose that disposable income, consumption, and saving in some country are $200 billion,

$150 billion, and $50 billion, respectively. Next, assume that disposable income increases by $20

billion, consumption rises by $18 billion and saving goes up by $2 billion. What is the economy’s

MPC? Its MPS? What was the APC before the increase in disposable income? After the increase?

LO1

3. ADVANCED ANALYSIS Suppose that the linear equation for consumption in a hypothetical

economy is C = 40 + .8Y. Also suppose that income (Y) is $400. Determine (a) the marginal

propensity to consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the

average propensity to consume, (e) the level of saving, and (f) the average propensity to save.

LO1

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4. ADVANCED ANALYSIS Linear equations for the consumption and saving schedules take

the general form C = a + bY and S= -a + (1-b)Y where C, S, and Y are consumption, saving, and

national income, respectively. The constant a represents the vertical intercept, and b represents

the slope of the consumption schedule. LO1, LO2

a. Use the following data to substitute numerical values for a and b in the consumption and saving

equations.

b. What is the economic meaning of b? Of (1 – b)?

c. Suppose that the amount of saving that occurs at each level of national income falls by $20 but

that the values of b and (1 – b) remain unchanged. Restate the saving and consumption equations

inserting the new numerical values, and cite a factor that might have caused the change.

Feedback: Finding the consumption function: The intercept a is the level of consumption

when income is zero. Thus, a = $80.

The slope of the consumption function b is found by looking at the change in

consumption relative to the change in income. This is the marginal propensity to consume

Finding the saving function: The intercept –a is the level of saving when income is zero.

If consumption is positive when income is zero there must be dissaving. Thus –a =-$80.

The slope of the saving function (1–b) is found by looking at the change in saving relative

to the change in income. This is the marginal propensity to save (MPS).

Part b:

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The slope of the consumption function b is the marginal propensity to consume (MPC).

b = MPC = Δ Consumption/Δ Income = $60/$100 =0.6

This implies that $0.60 of every additional dollar of disposable income will be consumed.

The slope of the saving function (1–b) is the marginal propensity to save (MPS).

MPS (1-b) = 1-MPC = 1- 0.6 = 0.4 = Δ saving/Δ Income = $40/$100

This implies that $0.40 of every additional dollar of disposable income will be saved.

Part c:

If saving falls by $20 at every level of national income this implies consumption

increases by $20 at every level of income. Thus, the intercept of the consumption

function a will increase by $20 and the intercept of the saving function –a will fall by

$20.

C = $100 + 0.6xY

S = -$100 + 0.4xY

5. Use your completed table for problem 1 to solve this problem. Suppose the wealth effect is

such that $10 changes in wealth produce $1 changes in consumption at each level of income. If

real estate prices tumble such that wealth declines by $80, what will be the new level of

consumption at the $340 billion level of disposable income? The new level of saving? LO2

6. Suppose a handbill publisher can buy a new duplicating machine for $500 and the duplicator

has a 1-year life. The machine is expected to contribute $550 to the year’s net revenue. What is

the expected rate of return? If the real interest rate at which funds can be borrowed to purchase

the machine is 8 percent, will the publisher choose to invest in the machine? Will it invest in the

machine if the real interest rate is 9 percent? If it is 11 percent? LO3

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Feedback:

The expected rate of return equals the expected net revenue less cost divided by the cost

7. Assume there are no investment projects in the economy that yield an expected rate of return of

25 percent or more. But suppose there are $10 billion of investment projects yielding expected

returns of between 20 and 25 percent; another $10 billion yielding between 15 and 20 percent;

another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present

them graphically, putting the expected rate of return (and the real interest rate) on the vertical axis

and the amount of investment on the horizontal axis. What will be the equilibrium level of

aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent?

LO3

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Feedback:

The firm will only make an investment if the expected return is greater than or equal to

8. Refer to the table in Figure 30.5 in the book and suppose that the real interest rate is 6 percent.

Next, assume that some factor changes such that that the expected rate of return declines by 2

percentage points at each prospective level of investment. Assuming no change in the real interest

rate, by how much and in what direction will investment change? Which of the following might

cause this change: (a) a decision to increase inventories; (b) an increase in excess production

capacity? LO4

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Feedback:

Since the expected rate of return has fallen by 2 percentage points investment at each real

interest rate will decrease. The investment schedule will shift to the left.

(b) an increase in excess production capacity?

9. What will the multiplier be when the MPS is 0, .4, .6, and 1? What will it be when the MPC is

1, .90, .67, .50, and 0? How much of a change in GDP will result if firms increase their level of

investment by $8 billion and the MPC is .80? If the MPC instead is .67? LO5

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Feedback: The multiplier = 1/MPS = 1/(1-MPC)

What will the multiplier be when the MPS is 0? infinity or undefined

What will the multiplier be when the MPS is 0.4? 2.5 (= 1/0.4)

What will the multiplier be when the MPS is 0.6? 1.6667 (= 1/0.6)

What will the multiplier be when the MPS is 1? 1 (= 1/1)

What will the multiplier be when the MPC is 1? infinity or undefined

What will the multiplier be when the MPC is 0.90? 10 (= 1/(1-0.9) = 1/0.1)

What will the multiplier be when the MPC is 0.67? 3.0303 (= 1/(1-0.67) = 1/0.33)

Could also answer 3.

What will the multiplier be when the MPC is 0.50? 2 (= 1/(1-0.5) = 1/0.5)

What will the multiplier be when the MPC is 0? 1 (= 1/1)

How much of a change in GDP will result if firms increase their level of investment by

$8 billion and the MPC is .80?

The multiplier here is 5 (1/(1-0.8)). We multiply this times the initial change in

investment to find the complete effect on GDP. GDP will change by $40 billion (= 5 x $8

billion).

If the MPC were instead 0.67 the change GDP equals $24 billion (approx). The multiplier

is 3 (approx) in this case.

10. Suppose that an initial $10 billion increase in investment spending expands GDP by $10

billion in the first round of the multiplier process. If GDP and consumption both rise by $6 billion

in the second round of the process, what is the MPC in this economy? What is the size of the

multiplier? If, instead, GDP and consumption both rose by $8 billion in the second round, what

would have been the size of the multiplier? LO5