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Chapter 28 - Basic Macroeconomic Relationships

McConnell Brue Flynn 20e


DISCUSSION QUESTIONS
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.
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.
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.
b. This will increase investment demand causing the investment curve to shift to the right. The
decrease in business taxes increase after-tax expected returns (which determines investment
decisions).
c. This will increase investment demand causing the investment curve to shift to the right. The
expected return increases due to the declining cost.
d. This will decrease investment demand causing the investment curve to shift to the left.
Widespread pessimism about future business conditions and sales revenues reduces expected
returns.
e. This will increase investment demand causing the investment curve to shift to the right. The
major new technological breakthrough increases expected returns.
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.
Answers: (a) data in the completed table; (b) $260, dissaving; (c) constant, variable, constant,
variable.
Feedback: Part a:
Level of
Output
and
Income
(GDP=DI)
$240
260
280
300
320
340
360
380
400

Consumptio
n
$244
$260
$276
$292
$308
$324
$340
$356
$372

Saving

APC

APS

MPC

MPS

-$4
0
4
8
12
16
20
24
28

1.0167
1
0.9857
0.9733
0.9625
0.9529
0.9444
0.9368
0.93

-0.0167
0
0.0143
0.0267
0.0375
0.0471
0.0556
0.0632
0.07

0.8
0.8
0.8
0.8
0.8
0.8
0.8
0.8
0.8

0.2
0.2
0.2
0.2
0.2
0.2
0.2
0.2
0.2

To find the level of consumption (column 2):


Consumption = Income - Saving
Example: at Income $300 Consumption = $300 - $8 = $292
To find the Average Propensity to Consume (APC) (column 4):
APC = Consumption/Income
Example: at Income $300 APC = $292/$300 = 0.9733
To find the Average Propensity to Save (APS) (column 5):
APS = Saving/Income
Example: at Income $300 APS = $8/$300 = 0.0267
To find the Marginal Propensity to Consume (MPC) (column 6):
MPC = Consumption/ Income
Example: at Income $300 (from $280) MPC = $16/$20 = 0.8
To find the Marginal Propensity to Save (MPS) (column 7):
MPS= Saving/ Income

Example: at Income $300 (from $280) MPS = $4/$20 = 0.2


Part b:
Break-even level of income is where saving equals zero (consumption equals income). Thus, the
break-even level of income is $260.
At the level of income $240 saving is negative. Economists refer to this as dissaving.
Part c:
MPS: Constant (does not change with income)
APC: Variable (changes with income)
MPC: Constant (does not change with income)
APS: Variable (changes with income)
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 economys MPC? Its MPS?
What was the APC before the increase in disposable income? After the increase? LO1
Answers: .9; .1; .75; .764.
Feedback:
To find the Marginal Propensity to Consume (MPC): MPC = Consumption/ Income
MPC = $18/$20 =0.9
To find the Marginal Propensity to Save (MPS): MPC = Saving/ Income
MPS = $2/$20 =0.1
To find the Average Propensity to Consume (APC): APC = Consumption/Income
APC = $150/$200 = 0.75
Disposable Income after the change equals $220 (=$200 +$20)
Consumption after the change equals $168 (= $150 +$18). The MPC is 0.9, so consumption
increases by $18 given the increase in disposable income of $20.
APC = $168/$220 = 0.7636