Answer Key to Selected Problems in Chapter 28

Economics (II), Spring 2022

1. In an economy, when income increases from $400 billion to $500

billion, consumption expenditure changes from $420 billion to
$500 billion. Calculate the marginal propensity to consume,
the change in saving, and the marginal propensity to save.
The marginal propensity to consume is the fraction of a change in disposable income that is
consumed. In this economy, when income increases by $100 billion per year, consumption
expenditure increases by $80 billion per year. The marginal propensity to consume equals
$80 billion ÷ $100 billion, or 0.8.

Saving equals disposable income minus consumption expenditure. Therefore from the $100
billion increase in income, consumption expenditure increased by $80 billion, leaving a $20
billion increase in saving. The marginal propensity to save is the fraction of a change in
disposable income that is saved. In this economy, for the increase in income of $100 billion,
saving increases by $20 billion, so the marginal propensity to save is $20 billion ÷ $100
billion, which is 0.2.

Use Figure 28.1 to work Problems

2 and 3.
Figure 28.1 illustrates the
components of aggregate planned
expenditure on Turtle Island.
Turtle Island has no imports or
exports, no incomes taxes, and the
price level is fixed.
2. Calculate autonomous
expenditure and the marginal
propensity to consume.
Autonomous expenditure is $2 billion.
Autonomous expenditure is expenditure that does not depend on real GDP. Autonomous expenditure
equals the value of aggregate planned expenditure when real GDP is zero.
The marginal propensity to consume is 0.6. When the country has no imports or exports and no income
taxes, the slope of the AE curve equals the marginal propensity to consume. When income increases
from zero to $6 billion, aggregate planned expenditure increases from $2 billion to $5.6 billion. That is,
when real GDP increases by $6 billion, aggregate planned expenditure increases by $3.6 billion. The
marginal propensity to consume is $3.6 billion ÷ $6 billion, which is 0.6.

3. a. What is aggregate planned expenditure when real GDP is $6

billion?
Figure 28.1 shows that aggregate planned expenditure is $5.6 billion when real GDP is $6 billion.
b. If real GDP is $4 billion, what is happening to inventories?
Firms’ inventories are decreasing. When real GDP is $4 billion, aggregate planned expenditure exceeds
real GDP, so firms sell all that they produce and more. As a result, inventories decrease.
c. If real GDP is $6 billion, what is happening to inventories?
Firms are accumulating inventories. That is, unplanned inventory investment is positive. When real
GDP is $6 billion, aggregate planned expenditure is less than real GDP. Firms cannot sell all that they
produce and inventories pile up.

4. Explain the difference between induced consumption expenditure

and autonomous consumption expenditure. Why isn’t all
consumption expenditure induced expenditure?
Induced consumption expenditure is consumption expenditure that changes when
disposable income changes. Autonomous consumption expenditure is consumption
expenditure that would occur in the short run even if disposable income was zero. Not all
consumption expenditure is induced consumption expenditure because, in the short run,
even if someone has no income they still will have some (autonomous) consumption
expenditure, if for nothing else, for food.
5. Explain how an increase in business investment at a constant
price level changes equilibrium expenditure.
Investment is a component of autonomous aggregate expenditure. An increase in investment
increases aggregate expenditure so the AE curve shifts upward. Equilibrium expenditure
increases.

Use the following data to work Problems 6 and 7.

An economy has a fixed price level, no imports, and no income taxes.
MPC is 0.80, and real GDP is $150 billion. Businesses increase
investment by $5 billion.
6. Calculate the multiplier and the change in real GDP.
With no imports and no income taxes, the multiplier equals 1/(1  MPC). So the multiplier is 1/(1 
0.8), which is 5.0. Then the $5 billion increase in investment increases real GDP by 5.0 × $5 billion,
which is $25 billion.

7. Calculate the new real GDP and explain why real GDP increases
by more than $5 billion.
Real GDP was initially $150 billion. The increase in investment increased real GDP by $25 billion, so
real GDP increases to $175 billion. Real GDP increases by more than the initial increase in investment
because the increase in investment increases disposable income which induces additional increases in
consumption expenditure. So real GDP increases both because investment increases and also because
of induced increases in consumption expenditure.

8. An economy has a fixed price level, no imports, and no income

taxes. An increase in autonomous expenditure of $2 trillion
increases equilibrium expenditure by $8 trillion. Calculate
the multiplier and explain what happens to the multiplier if
an income tax is introduced.
The multiplier is defined as the change in equilibrium expenditure divided by the change in
autonomous expenditure. In this problem the multiplier equals $8 trillion ÷ $2 trillion which
is 4.0.

If an income tax is introduced, the multiplier decreases in value. With an income tax, at
each spending round less disposable income is created leading to smaller increases in
induced expenditure.

Use the following data to work Problems 9 to 13.

Suppose that the British economy is at full employment, the price
level is 120, and the multiplier is 2.5. Investment decreases by
£150 billion.
9. What is the change in equilibrium expenditure if the price level
remains at 120?
The initial change in equilibrium expenditure is - £375. The initial effect of the decrease in investment
decreases equilibrium expenditure by the change in investment times the multiplier. The multiplier is
2.5 and the change in investment is -£150 billion, so the initial change in equilibrium expenditure is
-£375 billion.

10. a. What is the immediate change in the quantity of real GDP

demanded?
The quantity of real GDP demanded decreases by £375 billion. The decrease in investment shifts the
aggregate demand curve leftward by the change in investment times the multiplier. The multiplier is 2.5 and
the change in investment is -£150 billion, so the aggregate demand curve shifts leftward by £375 billion.
b. In the short run, does real GDP decrease by more than, less
than, or the same amount as the immediate change in the
quantity of real GDP demanded?
In the short run, real GDP decreases by less than £375 billion. Real GDP is determined at the
intersection of the AD curve and the SAS curve. As AD shifts to the left in the short run, the price level
will fall and real GDP will decrease but by an amount less than the shift of the AD curve because the
price level is not the same.

11. In the short run, does the price level remain at 120? Explain
why or why not.
In the short run, the price level falls. Real GDP is determined at the intersection of the AD curve and
the SAS curve. In the short run, the decrease in aggregate demand means that the price level will fall as
the economy moves backwards along its upward-sloping SAS curve.

12. a. In the long run, does real GDP decrease by more than, less
than, or the same amount as the immediate decrease in the
quantity of real GDP demanded?
In the long run, real GDP equals potential GDP, so real GDP does not decrease. Real GDP is
determined at the intersection of the AD curve and the SAS curve. After the initial decrease in
investment, money wages decrease, the SAS curve shifts rightward, and in the long run, real GDP
moves back to potential GDP.
b. Explain how the price level changes in the long run.
In the long run, money wages decrease. This causes the SAS curve to shift rightward decreasing the
price level by more than its fall in the short run.

13. Are the values of the multipliers in the short run and the long
run larger or smaller than 2.5?
The multiplier in the short run is less than the multiplier of 2.5 because the short-run decrease in real
GDP is less than £375 billion. The long-run multiplier is zero because real GDP went back to potential
GDP so it changed back to its initial value.

Mathematical Note
14. Use the data in the Worked Problem on p.738 to calculate the
change in equilibrium expenditure when investment decreases
by $150 billion.
The multiplier equals 4. Consequently the change in equilibrium expenditure equals (4) × (−$150
billion), or a decrease of $600 billion.