Chapter 10 – Basic Macroeconomic Relationships
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Chapter 10 Basic Macroeconomic Relationships
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
consumption and the variable on the horizontal axis (x-axis) is disposable income (see
Figure 27.2a).
2. 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
compare a change in consumer spending to a change in income: MPC = change in C /
3. 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
shift upward given the decrease in wealth.
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4. 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 consumption
or saving, then if you consume less out of any given income, you will necessarily save
5. 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.
6. 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.
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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
to the left. The increase in unused capacity reduces the need (expected return) for capital.
7. 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, investment
8. 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 machines and
9. 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:
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10. 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 includes
11. 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 on
PROBLEMS
1. Refer to the incomplete table below. LO1
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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.
Feedback: Consider the following example. Refer to the nearby incomplete table.
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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
To find the Average Propensity to Consume (APC) (column 4):
APC = Consumption/Income
Example: at Income $300 APC = $292/$300 = 0.9733
Part 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?
300
$292
8
0.8
0.2
320
$308
0.9625
0.0375
0.8
0.2
340
$324
0.8
0.2
360
$340
0.8
0.2
380
$356
0.9368
0.0632
0.8
0.2
400
$372
0.8
0.2
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Part 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.
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
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?
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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
Feedback: Consider the following example. 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.
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.
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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: Consider the following example. Part a:
Use the following data to substitute numerical values for a and b in the consumption and
saving equations.
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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
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
Feedback: Consider the following example. 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?
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TABLE FROM PROBLEM 1
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
Feedback: Consider the following example. 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?
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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
Answer:
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Feedback: Consider the following example. 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?
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8. Refer to the table in Figure 27.5 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
Feedback: Consider the following example. Refer to the table below 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?
Chapter 10 – Basic Macroeconomic Relationships
The next question is by how much?
To answer this question we use the following logic.
Initially investment at the real interest rate of 6% is $25 billion (see figure 27.5 above).
Which of the following might cause this change: (a) a decision to increase inventories;
(b) an increase in excess production capacity?
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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
Feedback: Consider the following example. 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?
The multiplier = 1/MPS = 1/(1-MPC)
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)
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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
Answers: .6; 2.5; 5.
Feedback: Consider the following example. 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?