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[solution]: ECN 211 - HW#5 (15 points) Ch. 14 Part 1: Questions for review

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ECN 211 - HW#5 (15 points)

Ch. 14

Part 1: Questions for review Ch. 14: the aggregate expenditure model - (1pt each):

1. a) Consumption expenditure is the expenditure by households on consumption of goods and services. The main

factors that help influence consumption expenditure include; disposable income, real interest rate, wealth, and

expected future income. I found that list in the book, page 351. I also saw in your lecture notes you listed; consumer

spending, gross private domestic investment spending, and net exports. I believe you wanted the list given in your

lecture notes.

b) A fall in the interest rate or an increase in either wealth of expected future income increases consumption

expenditure and shifts the function up.

2. A) Marginal Propensity to Consume is the fraction of a change in disposable income that is spent on consumption.

B) MPC = Change in consumption expenditure

Change in disposable income

3. In the definition of the MPC, it states that it is a fraction. This means that the MPC will stay under one.

( I tried finding this more in depth in the book and couldn?t seem to figure it out, not sure if it is the correct answer)

4. A) Induced expenditure equals consumption expenditure minus imports; it also increases as real GDP increases.

Autonomous expenditure is expenditure that does not respond directly to changes in the real GDP.

B) Autonomous expenditure components include investment, government expenditure on goods and services,

exports, and autonomous consumption expenditure. Induced expenditure does vary when it comes to the real GDP,

the components of induced expenditure are imports and consumption expenditure.

5. A) An aggregate expenditure schedule and an aggregate expenditure curve describe the relationship between

aggregate planned expenditure and the real GDP. Aggregate planned expenditure increases as real GDP increase.

B) When aggregate planned expenditure exceeds real GDP; an unplanned decrease in inventories occurs. Firms

increase production, and real GDP increases. When real GDP exceeds aggregate planned expenditure, an unplanned

increase in inventories occurs. Firms decrease production, and real GDP decreases.

6. A) In Say?s book, he explains that supply creates its own demand. This idea soon became Say?s Law. His work is

shown when the economy is at full-employment. When the Great Depression occurred, Say?s law became under

attacked. It seemed as if supply didn?t create its own demand, but there was nothing to compare his law too. John

Keynes, in the middle of the Great Depression, created effective demand. Keynes turned Say?s Law around. He

determined that supply does not create its own demand, and effective demand determines real GDP

B) Keynes believed if businesses spend less on the new capital than the amount that people save, equilibrium

expenditure will be less than potential GDP. Say?s believed the real wage rate adjusts to ensure that the quantity of

labor demanded equals the quantity of labor supplied and real GDP equals potential GDP. The real interest rate

adjusts to ensure that the quantity of investment that firms plan equals the quantity of saving. Because saving equals

income minus the consumption expenditure plus investment exactly equals the potential GDP.

7. A) The basic idea of the multiplier; an increase in investment increases real GDP, which increases disposable income

and consumption expenditure. The increase in consumption expenditure adds to the increase in investment and a

multiplier determines the magnitude of the resulting increase in aggregate expenditure.

B) When imports and income taxes are ignored, the magnitude of the multiplier solely depends on the MPC. The

greater the MPC, the larger is the multiplier.

Part 2: Application problems; ch. 14 - (1pt each, unless noted otherwise):

1. Suppose you are given the following information for the economy of New New York:

Disposable Income

(DI)

$0

$100

$200

$300

Consumption

Spending (C)

$20

$110

$200

$290

Savings (S)

ECN 211 - HW#5 (15 points)

Ch. 14

$400

$500

$380

$470

Please calculate the following based on the above table:

a. What is the level of savings (S) when disposable income (DI) is $400?

b. What is the marginal propensity to consume (MPC) for New New York. Make sure to show your work

and write down any formulas you used.

2. Shifts in the consumption function. For each of the following, state whether there would be:

a. There is an increase in real interest rates. This would cause a downward shift. This shift occurs during a

recession if a stock market crash decreases wealth and expected future income decreases.

b. Consumers expect to have more income in the future. This would cause an upward shift. This is because

there is an expansion in the business cycle.

c. There is increase in households? stock portfolio balances (i.e. wealth). This would also cause an upward

shift.

3. Shifts in the aggregate expenditure (AE) function. For each of the following, state whether there would be:

an increase in AE in Springfield (i.e. shift Springfield?s AE function UP), or

a decrease in AE in Springfield (i.e. shift Springfield?s AE function DOWN).

Also, provide a brief explanation for each answer.

a. There is a decrease in real interest rates.

b. There is a recession in Shelbyville (one of Springfield?s major trading partners), reducing the incomes of

people in Shelbyville.

c. Springfield?s government decides to increase government spending on Springfield?s crumbling

infrastructure and public school system.

4. The AE function: The below figure shows the AE curve and 45° line for an economy.

a. What is the equilibrium level of expenditure?

b. If real GDP equals $10 trillion (and planned AE is $12.5 trillion), what would be the amount of the unplanned

change to inventories? Would firms have an incentive to increase or decrease production? Why?

c. If real GDP equals $20 trillion (and planned AE is $17.5 trillion), what would be the amount of the unplanned

change to inventories? Would firms have an incentive to increase or decrease production? Why?

ECN 211 - HW#5 (15 points)

Ch. 14

5. Calculating the simple spending multiplier:

a. Suppose that MPC = 0.5 Please calculate the spending multiplier. You must write down the appropriate

formula and show all of your work.

b. Suppose that MPC = 0.8 Please calculate the spending multiplier. You must write down the appropriate

formula and show all of your work.

6. Using the multiplier:

a. Suppose in Illiniland, the spending multiplier is 3. By how much would aggregate expenditures (AE) need to

change in order to create a $1,200,000 decrease in equilibrium real GDP? Write down the appropriate formula

and show all of your work. In your answer, be sure to indicate whether the change in AE is a(n)

increase or decrease.

b. In North Haverbrook, suppose that when AE increases by $56,000, this causes equilibrium real GDP to increase

by $336,000. What is the value of the spending multiplier? Write down the appropriate formula and show all

of your work.

7. Below is the relevant data for the economy of ItchyandScratchyland (2pts total)

DI = GDP

Consumption (C)

Investment

(I)

Government

(G)

Net Exports

Planned AE

(X-M)

$0

$150

$300

$850

-$300

$2,000

$1,650

$300

$850

-$300

$4,000

$3,150

$300

$850

-$300

$6,000

$4,650

$300

$850

-$300

$8,000

$6,150

$300

$850

-$300

$10,000

$7,650

$300

$850

-$300

Unplanned change

to inventory

a. For this economy:

i. What is the level of equilibrium real GDP?

ii. Calculate the MPC. Show your work.

iii. Calculate the value of the spending multiplier. Show your work.

b. Suppose that the President of ItchyandScratchyland, Roger Meyers, Jr., decided to increase government

spending by $500.

i.

By how much would equilibrium real GDP change as a result of this change in spending

(also indicate increase or decrease)? Show your work.

ii.

What would be the new level of equilibrium real GDP? Show your work.

Want extra practice? Yes! Try #1-8 on pg. 370 and #1-6, and 9 on pg. 371

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