Macroeconomics, 7e (Blanchard)

Chapter 3: The Goods Market

3.1 The Composition of GDP

1) For the U.S. economy, which of the following represents the largest component of GDP?
A) imports
B) investment
C) government spending
D) exports
E) none of the above
Answer: E
Diff: 1

2) Which of the following types of government spending is included when calculating GDP?
A) spending at the federal level
B) spending at the state level
C) spending at the municipal level
D) all of the above
E) only A and B
Answer: D
Diff: 1

3) Which of the following would not be considered part of fixed investment spending (I)?
A) Toyota buys a new robot for its automobile assembly line.
B) Apple computer builds a new factory.
C) Exxon increases its inventories of unsold gasoline.
D) An accountant buys a newly built home for herself and her family.
E) all of the above
Answer: C
Diff: 1

4) Which of the following is true for a "closed economy"?

A) government spending equals taxes
B) there are no imports or exports
C) exports equal imports
D) there is no saving
E) there is no government spending or taxes
Answer: B
Diff: 1

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5) Which of the following is an exogenous variable in our model of the goods market in Chapter
3?
A) consumption (C)
B) saving (S)
C) disposable income (YD)
D) government spending (G)
E) none of the above
Answer: D
Diff: 2

6) Which of the following is an endogenous variable in our model of the goods market in
Chapter 3?
A) consumption (C)
B) disposable income (YD)
C) saving (S)
D) total income (Y)
E) all of the above
Answer: E
Diff: 2

7) Discuss the two components of fixed investment.

Answer: Nonresidential investment represents the purchase of new equipment and structures.
Residential investment represents the purchase by people of new homes, condos, and apartments.
Diff: 1

3.2 The Demand for Goods

1) Disposable income equals

A) income minus saving.
B) income minus both saving and taxes.
C) consumption minus taxes.
D) the sum of consumption and saving.
E) none of the above
Answer: D
Diff: 1

2) The marginal propensity to consume represents

A) the level of consumption that occurs if disposable income is zero.
B) the ratio of total consumption to disposable income.
C) total income minus total taxes.
D) the change in output caused by a one-unit change in autonomous demand.
E) the change in consumption caused by a one-unit change in disposable income.
Answer: E
Diff: 1

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3) Let the consumption function be represented by the following equation: C = c0 + c1YD. For
this equation, we assume that c1 is
A) negative.
B) larger than c0.
C) different at different levels of income.
D) equal to one.
E) none of the above
Answer: E
Diff: 1

4) Suppose the consumption equation is represented by the following: C = 250 + .75YD. The
multiplier in this economy is
A) .25.
B) .75.
C) 1.
D) 4.
E) 5.
Answer: D
Diff: 2

5) Suppose the consumption equation is represented by the following: C = 250 + .75YD. Given
this information, the marginal propensity to save is
A) .25.
B) .7.
C) 1.
D) 4.
E) none of the above
Answer: A
Diff: 2

6) Which of the following occurs when disposable income is zero?

A) consumption must be zero
B) saving must be zero
C) saving must be positive
D) consumption is negative
E) none of the above
Answer: E
Diff: 2

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3.3 The Determination of Equilibrium Output

1) Equilibrium in the goods market requires that

A) production equals income.
B) production equals demand.
C) consumption equals saving.
D) consumption equals income.
E) government spending equals taxes minus transfers.
Answer: B
Diff: 1

2) An economy is in equilibrium when which of the following conditions is satisfied?

A) consumption equals saving
B) output equals consumption
C) total saving equals zero
D) total saving equals investment
E) all of the above
Answer: D
Diff: 1

3) Which of the following is included in G?

A) medicare
B) social security payments
C) interest payments on the government debt
D) government purchases
E) all of the above
Answer: D
Diff: 2

4) Suppose the consumption equation is represented by the following: C = 250 + .8YD. The
multiplier for the above economy equals
A) 2.
B) 3.
C) 4.
D) 5.
E) none of the above
Answer: D
Diff: 2

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5) Suppose the consumption equation is represented by the following: C = 250 + .75YD. Now
assume government spending increases by 100 for the above economy. Given the above
information, we know that equilibrium output will increase by
A) 200.
B) 400.
C) 800.
D) 1000.
E) none of the above
Answer: B
Diff: 2

6) Which of the following will not increase equilibrium output in the short run?
A) increases in R&D
B) increases in consumer confidence
C) increases in investment demand
D) increases in government spending
E) decreases in taxes
Answer: A
Diff: 2

7) Which of the following would tend to make the multiplier smaller?

A) an increase in the marginal propensity to consume
B) an increase in the marginal propensity to save
C) a reduction in taxes
D) a reduction in government spending
E) none of the above
Answer: B
Diff: 2

8) Which of the following represents total saving for an economy?

A) the sum of private saving and fixed investment
B) the sum of private saving and consumption
C) the sum of taxes and government spending
D) the excess of taxes over government spending
E) none of the above
Answer: E
Diff: 1

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9) Based on our understanding of the paradox of saving, we know that a reduction in the desire
to save will cause
A) an increase in equilibrium GDP.
B) a reduction in GDP.
C) an increase in the desire to invest.
D) no change in equilibrium GDP.
E) a permanent reduction in the level of saving.
Answer: A
Diff: 2

10) Which of the following events will cause a reduction in equilibrium output?
A) an increase in the marginal propensity to save
B) an increase in taxes
C) a reduction in the marginal propensity to consume
D) all of the above
E) none of the above
Answer: D
Diff: 2

11) Based on our understanding of consumption and saving, we know that the marginal
propensity to consume and the marginal propensity to save must
A) be equal to each other.
B) sum to exactly one.
C) sum to less than one.
D) sum to more than one.
E) be equal to the multiplier.
Answer: B
Diff: 1

12) Suppose there is an increase in autonomous consumption. Specifically, suppose c0 increases

where C = c0 + c1YD. This increase in autonomous consumption will cause which of the
following to increase?
A) equilibrium income
B) equilibrium disposable income
C) demand
D) all of the above
E) none of the above
Answer: D
Diff: 2

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13) If C = 2000 + .9YD, what increase in government spending must occur for equilibrium
output to increase by 1000?
A) 100
B) 200
C) 250
D) 500
E) 1000
Answer: A
Diff: 2

14) Which of the following equals demand in an open economy?

A) C + I + G + X
B) C + I + G + X - IM
C) C + I + G + IM - X
D) C + I + G
Answer: B
Diff: 1

15) Which of the following equals demand in a closed economy?

A) C + I + G + X
B) C + I + G + X - IM
C) C + I + G + IM - X
D) none of the above
Answer: D
Diff: 1

16) Suppose an open economy is in equilibrium. Given this information, we know with certainty
that
A) G = T.
B) X = IM.
C) S = I.
D) Y = Z.
Answer: D
Diff: 1

17) For a closed economy, which of the following conditions must be satisfied for equilibrium to
be maintained?
A) G = T
B) X = IM = 0
C) C = S
D) none of the above
Answer: D
Diff: 2

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18) Autonomous spending in a closed economy equals which of the following?
A) c0 + I + G - c1T
B) C + I + G
C) Z
D) c0 + I + G + c1T
Answer: A
Diff: 2

19) Based on our understanding of the model presented in Chapter 3, we know that an increase in
c1 (where C = c0 + c1YD) will cause
A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
smaller effect on output.
B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
larger effect on output.
C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
smaller effect on output.
D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
larger effect on output.
Answer: B
Diff: 2

20) Based on our understanding of the model presented in Chapter 3, we know that a reduction in
c1 (where C = c0 + c1YD) will cause
A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
smaller effect on output.
B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
larger effect on output.
C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
smaller effect on output.
D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
larger effect on output.
Answer: C
Diff: 2

21) An increase in the marginal propensity to save from .3 to .4 will cause

A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
smaller effect on output.
B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
larger effect on output.
C) the ZZ line to become flatter and a given change in autonomous consumption (c0)) to have a
smaller effect on output.
D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
larger effect on output.
Answer: B
Diff: 2
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22) A reduction in the marginal propensity to save from .4 to .3 will cause
A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
smaller effect on output.
B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a
larger effect on output.
C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
smaller effect on output.
D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a
larger effect on output.
Answer: C
Diff: 2

23) An increase in the marginal propensity to save from .1 to .2 will cause

A) an increase in the multiplier and a given change in autonomous consumption (c0) to have a
smaller effect on output.
B) an increase in the multiplier and a given change in autonomous consumption (c0) to have a
larger effect on output.
C) a reduction in the multiplier and a given change in autonomous consumption (c0) to have a
smaller effect on output.
D) a reduction in the multiplier and a given change in autonomous consumption (c0) to have a
larger effect on output.
Answer: C
Diff: 2

24) When the economy is in equilibrium, we know with certainty that

A) public saving equals investment.
B) private saving equals investment.
C) G = T.
D) none of the above
Answer: D
Diff: 1

25) When a closed economy is in equilibrium, we know with certainty that

A) I = S + (T - G).
B) I = S.
C) I = S + (G - T).
D) G = T and S = I.
Answer: A
Diff: 1

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26) An increase in the desire to save by households will cause
A) a reduction in output.
B) a reduction in investment.
C) an increase in output.
D) no change in investment and no change in output.
Answer: A
Diff: 2

27) An increase in taxes will cause

A) a reduction in investment.
B) an increase in investment.
C) no change in investment.
D) no change in autonomous spending.
Answer: C
Diff: 2

28) A tax cut will cause

A) a reduction in investment.
B) an increase in investment.
C) no change in investment.
D) no change in autonomous spending.
Answer: C
Diff: 2

29) Based on our understanding of the model presented in Chapter 3, we know with certainty
that an equal and simultaneous increase in G and T will cause
A) an increase in output.
B) no change in output.
C) a reduction in output.
D) an increase in investment.
Answer: A
Diff: 3

30) Based on our understanding of the model presented in Chapter 3, we know with certainty
that an equal and simultaneous reduction in G and T will cause
A) an increase in output.
B) no change in output.
C) a reduction in output.
D) an increase in investment.
Answer: C
Diff: 3

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31) Based on our understanding of the model presented in Chapter 3, a reduction in investment
will cause
A) an increase in the multiplier.
B) a reduction in the multiplier.
C) a reduction in the marginal propensity to save.
D) a reduction in output.
E) both B and D
Answer: D
Diff: 2

32) Suppose business confidence decreases causing a reduction in investment. Based on our
understanding of the model presented in Chapter 3, we know with certainty that a reduction in
investment will cause
A) an increase in the multiplier.
B) a reduction in the multiplier.
C) a reduction in the marginal propensity to save.
D) a reduction in consumption as the economy adjusts to this decrease in investment.
Answer: D
Diff: 2

33) Suppose the marginal propensity to consume equals .8 (i.e., c1 = .8). Given this information,
which of the following events will cause the largest increase in output?
A) G increases by 200
B) T decreases by 200
C) I increases by 150
D) both A and B
Answer: A
Diff: 3

34) Inventory investment refers to

A) the difference between production and sales in a given year.
B) fixed investment.
C) nonresidential investment.
D) the purchase by firms of new machines.
Answer: A
Diff: 3

35) Suppose the consumption equation is represented by the following: C = 250 + .75YD, then
private savings is
A) -250+0.25YD.
B) -250+0.75YD.
C) -1000+0.25YD.
D) -1000+0.75YD.
Answer: A
Diff: 3

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36) If C = 2000 + .9YD, what decrease in taxes must occur for equilibrium output to increase by
1000?
A) 111
B) 100
C) 1000
D) 500
Answer: A
Diff: 3

37) Suppose the United States economy is represented by the following equations:

Z = C + I + G C = 500 + .5YD T = 600 I = 300

YD = Y - T G = 2000

a. Given the above variables, calculate the equilibrium level of output. Hint: First specify (using
the above numbers) the demand equation (Z) for this economy. Second, using the equilibrium
condition, equate this expression with Y. Once you have done this, solve for the equilibrium
level of output. Using the ZZ-Y graph (i.e., a graph that includes the ZZ line and 45-degree line
with Z on the vertical axis, and Y on the horizontal axis), illustrate the equilibrium level of
output for this economy.
b. Now, assume that consumer confidence decreases causing a reduction in autonomous
consumption (c0) from 500 to 400. What is the new equilibrium level of output? How much does
income change as a result of this event? What is the multiplier for this economy?
c. Graphically illustrate the effects of this change in autonomous consumption on the demand
line (ZZ) and Y. Clearly indicate in your graph the initial and final equilibrium levels of output.
d. Briefly explain why this reduction in output is greater than (in absolute terms) the initial
reduction in autonomous consumption.
Answer:
a. Y = 5000. The graph is easy to show.
b. Y = 4800; the multiplier is 2.
c. Graph.
d. When demand falls by 100, firms cut production by 100. As production falls by 100, income
falls which causes a subsequent reduction in consumption and demand.This Y-induced fall in
demand causes another reduction in production. This continues and we observe a final change in
Y that exceeds the initial change in autonomous demand.
Diff: 2

38) Explain what the multiplier represents.

Answer: The multiplier illustrates the extent to which equilibrium output will change as a result
of a given change in autonomous demand.
Diff: 2

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39) Discuss and explain what effect a reduction in the marginal propensity to consume has on the
size of the multiplier.
Answer: A reduction in the marginal propensity to consume will cause a reduction in the
multiplier. When firms increase production in response to some initial change in demand,
households will increase their consumption by a smaller amount when the mpc falls. So, the
income-induced change in demand will be that much smaller causing a smaller multiplier effect.
Diff: 2

40) Use the ZZ-Y model presented in chapter 3 to illustrate the effects of a reduction in
consumer confidence on the economy. Also, explain what effect this reduction in consumer
confidence has on the economy.
Answer: The graph is easy. The reduction in consumer confidence will cause a reduction in
consumption and demand. As demand falls, firms will cut production. So, this event will cause a
lower level of equilibrium output.
Diff: 2

41) Suppose that, at a given level of disposable income, consumers decide to save more. Explain
what effect this decision will have on equilibrium income. Also, explain what effect this decision
will have on the level of saving once the economy has reached the new equilibrium.
Answer: This is the paradox of saving. Here, consumption will fall causing a reduction in
demand and a reduction in output. Despite the initial increase in saving at the initial level of
income, saving will return to the initial level as income falls in order to maintain the alternative
equilibrium condition: S = I. So, the initial increase in the desire to save will have no permanent
effect on the level of saving.
Diff: 2

42) Explain the difference between endogenous and exogenous variables.

Answer: Endogenous variables are determined by the model. Exogenous variables are taken as
given and, for example in this model, do not change as income changes.
Diff: 2

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3.4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market
Equilibrium

1) Which of the following about IS relation is not correct?

A) It is the the relation between interest rate and savings.
B) It is the equilibrium condition for the goods market.
C) It stands for "Investment equals saving."
D) It shows what firms want to invest must be equal to what people and the government want to
save.
Answer: A
Diff: 3

2) Discuss what is meant by the paradox of saving.

Answer: The paradox of saving refers to the effects of an increased desire to save on output and
on the final level of saving. The increased desire to save is equivalent to a reduction in
consumption. This drop in demand will cause a drop in output. Furthermore, in this simple
economy, the final level of saving will equal the initial level of saving. So, an increased desire to
save has a negative effect on the economy and has no permanent effect on the level of saving
(because S = I in the simple model).
Diff: 1

3.5 Is the Government Omnipotent? A Warning

1) Which of the following is corrrect?

A) Governments can not achieve the level of output they want.
B) Changing government spending or taxes is easy.
C) Investment will remain constant.
D) Expectations do not matter for government to change spending or taxes.
Answer: A
Diff: 1

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3.6 Essay Questions

1) For this question, assume that taxes are independent of income (i.e., the income tax rate is
zero). Now suppose that fiscal policy makers wish to decrease equilibrium output by $500
billion. Further suppose that policy makers can choose one of the following two options: (1)
change in government spending; or (2) change in taxes. Compare and explain the relative size of
the changes in government spending and taxes needed to obtain this desired change in output.
Answer: The change in taxes will have to be larger because part of any tax increase will cause
saving to fall. So, to cause the same reduction in demand, the size of the tax cut will have to be
larger than the size of any reduction in government spending.
Diff: 2

2) Explain what factors cause shifts and changes in the slope of the ZZ curve presented in
chapter 3.
Answer: The ZZ curve is upward sloping. The ZZ curve illustrates the level of demand at each
level of income. As Y increases, households consume more causing an increase in demand. So,
as Y rises, so does demand. The marginal propensity to consume will determine the size of the
slope. The ZZ curve will shift when any autonomous component of demand changes. This will
include changes in T, G, I and c0.
Diff: 2

3) Why would consumer decrease consumption even if their disposable income has not changed?
Answer: If consumers start worrying about the future and decide to save more, they will
decrease c0 and hence consumption. This is what happened at the start of the most recent
financial crisis.
Diff: 2

4) In the model discussed in Chapter 3, why do we assume G and T are exogenous?

Answer: It is based on two arguments: First, government do not behave with the same regularity
as consumers or firms, so there is no reliable rule we could write for G or T. Second, treating G
and T as exogenous help explore the implications of alternative spending and tax decisions.
Diff: 2

5) Suppose the United States economy is represented by the following equations:

Z=C+I+G C = 500 + .5YD T = 600 I = 300

YD = Y - T G = 2000

a. Given the above variables, calculate the equilibrium level of output.

b. Now, assume that government spending decreases from 2000 to 1900. What is the new
equilibrium level of output? How much does income change as a result of this event? What is the
multiplier for this economy?
Answer:
a. Y = 5000
b. Y = 4800, multiplier = 2.
Diff: 2

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6) Suppose the United States economy is represented by the following equations:

Z=C+I+G C = 500 + .5YD T = 600 I = 300

YD = Y - T G = 2000

a. Given the above variables, calculate the equilibrium level of output.

b. Now, assume that taxes increase from 600 to 700. What is the new equilibrium level of
output? How much does income change as a result of this event? What is the multiplier for this
economy?

Answer:
a. Y = 5000.
b. Y = 4900, multiplier = 2.
Diff: 2

7) Graphically illustrate the effects of an increase in autonomous consumption on the demand

line (ZZ) and Y. Clearly indicate in your graph the initial and final equilibrium levels of output.
Briefly explain why this increase in output is greater than (in absolute terms) the initial change in
autonomous consumption.
Answer: ZZ line will shift upward and Y will increase. The increase in output is greater than the
initial change in autonomous consumption is due to the multiplier effect.
Diff: 2

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