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ANS:
During a temporary growth slowdown, the real GDP growth rate declines but does not turn negative.
During a recession, the real GDP growth rate becomes negative.
2. Graphically show the difference between what is meant by a growth slowdown as opposed to a
recession.
ANS:
The figure below is an example of a growth slowdown. Notice that at point a, the rate of growth slows
down without turning negative. Sooner or later, there is a slump – if the growth rate of spending is less
than the growth rate of potential GDP.
The figure below is an example of a recession. Notice that at point a, the rate of growth becomes
negative.
5. Over the15 or 20 years before the global financial crisis, economic fluctuations
a. became more severe than in the past.
b. occurred more often than in the past.
c. had not changed in severity when compared to past economic fluctuations.
d. became less severe than in the past.
e. occurred just as often as in the past.
ANS: D PTS: 1 DIF: basic
NAT: Introduction
6. True or False. Economic fluctuations have been common for at least 200 years, but they have
diminished in frequency and severity in the United States and many other countries, particularly in the
last 25 years.
7. T or F. Economic fluctuations have been common only since the beginning of the 20th century, when
governments began to expand their interventions in markets.
9. The economist who, in the 1930s, stressed that the Great Depression was a result of insufficient
spending was
a. Milton Friedman.
b. Robert Malthus.
c. Alfred Marshall.
d. Joseph Schumpeter.
e. John Maynard Keynes.
ANS: E PTS: 1 DIF: moderate
NAT: Introduction
10. T or F. An improvement in consumer confidence will affect the growth rate of the economy.
11. T or F. A recession in other countries has no effect on forecasted growth in this country.
Exhibit 7.1
13. According to Exhibit 7.1, line abd shows the path of potential GDP. Suppose that the Year 2 spending
balance has the economy at point b where real GDP equals potential GDP. Which of the following
would cause the economy to be at point c in Year 3?
a. There is an increase in wealth.
b. Firms decrease their optimism about the state of the economy.
c. The marginal propensity to consume decreases.
d. The quantity of imports increases.
e. The government increases taxes.
ANS: A PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
14. According to Exhibit 7.1, line abd shows the path of potential GDP. In Year 2, suppose the
expenditure line intersects the 45-degree line at the level of spending corresponding to point b. If, in
Year 3, the economy is at point c, then
a. the expenditure line has shifted up the 45-degree line more than it would have if real GDP
equalled potential GDP in Year 3.
b. the expenditure line has shifted down the 45-degree line.
c. the expenditure line has shifted up the 45-degree line and equals a level of income greater
than real GDP.
d. the expenditure line has shifted up the 45-degree line to a point where real GDP equals
potential GDP in Year 3.
e. potential GDP has risen, and we’ve moved to a new point of spending balance.
ANS: A PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
15. According to Exhibit 7.1, line abd shows the path of potential GDP. In Year 2, suppose the
expenditure line intersects the 45-degree line at the level of spending corresponding to point b. If, in
Year 3, the economy is at point e, then
a. the expenditure line has shifted up the 45-degree line to a point where real GDP equals
potential GDP in Year 3.
b. the expenditure line has shifted up the 45-degree line, but the level of income is less than
the amount corresponding to real GDP.
c. the expenditure line has shifted down the 45-degree line.
d. the expenditure line has shifted up the 45-degree line more than it would have if real GDP
equalled potential GDP in Year 3.
e. potential GDP has declined, and we’ve moved to a new point of spending balance.
ANS: C PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
16. T or F. If the economy is growing along the same path as potential GDP, the expenditure line will not
shift over time.
Exhibit 7.2
18. According to Exhibit 7.2, which of the following is true?
a. All recessions are of the same duration.
b. In normal times, real GDP is above potential GDP.
c. Aggregate demand fell between year B and year D.
d. Potential GDP fell between year B and year D.
e. Unemployment rose between year D and year F.
ANS: C PTS: 1 DIF: basic
NAT: Changes in spending cause fluctuations in production
19. According to Exhibit 7.2, which of the following best explains the change in real GDP from year B to
year D?
a. The supply of labour fell.
b. Foreigners decided to purchase more of our goods.
c. The government cut taxes.
d. Consumers became more optimistic.
e. Firms became more pessimistic.
ANS: E PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
23. T or F. Potential GDP represents what firms would want to produce in ‘normal times’, when the
economy is in neither a recession nor a boom.
24. In mature economies, manufacturing capacity utilisation in normal times typically equals
a. 60 per cent.
b. 90 per cent.
c. 70 per cent.
d. 100 per cent.
e. 80 per cent.
ANS: E PTS: 1 DIF: basic
NAT: Changes in spending cause fluctuations in production
25. When the unemployment rate is equal to the natural unemployment rate, capacity utilisation in mature
economies is usually close to
a. 80 per cent.
b. 90 per cent.
c. 70 per cent.
d. 60 per cent.
e. 100 per cent.
ANS: A PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
27. When the unemployment rate drops below the natural unemployment rate,
a. the economy is in a recession.
b. real GDP is rising above potential GDP.
c. real GDP is falling below potential GDP.
d. the capacity utilisation rate is declining.
e. All of these.
ANS: B PTS: 1 DIF: moderate
NAT: Changes in spending cause fluctuations in production
28. Which of the following does not occur when real GDP rises above potential GDP?
a. The unemployment rate falls below the natural unemployment rate.
b. The capacity utilisation rate increases.
c. Firms increase their prices.
d. Capacity utilisation exceeds 100 per cent.
e. Demand increases.
ANS: D PTS: 1 DIF: basic
NAT: Changes in spending cause fluctuations in production
29. T or F. When firms are at full capacity, real GDP equals potential GDP.
30. T or F. In normal times, when the economy is in neither a recession nor a boom, manufacturing
capacity utilisation is at 100 per cent.
31. T or F. The actual unemployment rate will fall below the natural unemployment rate when real GDP
rises above potential GDP.
32. T or F. To forecast real GDP, economic forecasters divide aggregate demand into its four key
components: private sector, public sector, investment sector, and foreign sector.
33. Changes in total domestic spending mean that producers need to consider whether to change output or
change price or both. If price adjustment is small because of ____, the response of production is ____
a. menu costs ; small.
b. implicit contracts ; large.
c. limited information ; zero.
d. All of these.
e. nominal flexibilities ; zero
ANS: B PTS: 1 DIF: moderate
NAT: Limited information and implicit contracts
34. Suppose the economy is booming and many firms begin to experience an increase in the demand for
their goods and services.
a. Suppose the firms do not know whether the change is temporary or permanent. How will
they adjust price and output?
b. Suppose the firms determine that the change is permanent. How will they adjust price
and output?
c. Explain the relationship between imperfect information and economic fluctuations based
on your answers to (a) and (b) above.
ANS:
a. They will increase output first and decide on price later. Many firms have some excess
capacity, so they can easily adjust output first. The price adjustment will come later after
they evaluate whether the change is temporary or permanent. In addition, the idea of
implicit contracts suggests that firms are reluctant to change price frequently.
b. They will increase price. As price increases, some of the increase in demand will be
offset.
c. With imperfect information, firms adjust output first, based on demand, and price later.
Fluctuations are larger than if firms had perfect information, in which case firms would
change price for permanent changes but not for temporary changes.
35. Supporters of real business cycle theories argue that economic fluctuations are a response to changes
in
a. money velocity.
b. the money supply.
c. production possibilities.
d. real GDP.
e. aggregate demand.
ANS: C PTS: 1 DIF: basic
NAT: Could economic fluctuations also be due to changes in potential GDP?
36. A macroeconomic theory that stresses the fact that shifts in potential GDP are a primary cause of
fluctuations in real GDP is known as
a. potential GDP theory.
b. real business cycle theory.
c. economic cycle theory.
d. perennial growth theory.
e. None of these.
ANS: B PTS: 1 DIF: moderate
NAT: Could economic fluctuations also be due to changes in potential GDP?
37. Which of the following would a real business cycle theorist emphasise as a primary cause of economic
fluctuations?
a. Changes in the weather that severely impact the agricultural sector
b. Changes in investment spending
c. Changes in technology
d. Changes in taxes
e. Changes in government spending
ANS: C PTS: 1 DIF: moderate
NAT: Could economic fluctuations also be due to changes in potential GDP?
40. T or F. Real business cycle theories focus on changes in potential GDP as the source of economic
fluctuations.
41. T or F. In real business cycle theories, changes in tastes are most frequently assumed to be the reason
for changes in potential GDP.
42. T or F. Potential GDP growth is relatively smoother than aggregate demand growth.
43. Explain the connection between fluctuations in the unemployment rate around the natural rate of
unemployment and fluctuations in real GDP around potential GDP.
ANS:
Real GDP rises above potential GDP when aggregate demand rises. This increase in demand causes
firms to increase their capacity utilisation. As production expands, more workers are employed, thus
causing the unemployment rate to fall below the natural rate.
Real GDP falls below potential GDP when aggregate demand falls. The reduction in demand causes
firms to reduce their capacity. As production decreases, the amount of workers employed declines. The
decline in employment causes the unemployment rate to rise above the natural rate.
44. Is it possible for economic fluctuations to occur for reasons not associated with changes in aggregate
demand? Explain.
ANS:
Yes. Some economists believe that fluctuations can occur as a result of changes in potential GDP. In
particular, they argue that fluctuations are a response to technological shocks.
45. Why are most economists sceptical about the real business cycle theory of economic fluctuations?
ANS:
They are sceptical because the factors that determine potential GDP grow smoothly and gradually over
time. Aggregate demand, however, exhibits more variability in its growth.
49. The consumption function shows the relationship between consumption and
a. the interest rate.
b. the money supply.
c. the price level.
d. potential GDP.
e. income.
ANS: E PTS: 1 DIF: basic
NAT: Consumption spending during fluctuations in GDP
52. The relationship describing how consumption depends on income is known by economists as
a. the income function.
b. the budget constraint function.
c. the purchasing power function.
d. the affordability function.
e. None of these
ANS: E PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
Exhibit 7.3
54. Given the data in Exhibit 7.3, what is the marginal propensity to consume?
a. 0.80
b. 0.90
c. 0.75
d. 1.25
e. 0.60
ANS: A PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
55. Given the data in Exhibit 7.3, what is the level of consumption if income increases to 400?
a. 480
b. 450
c. 515
d. 465
e. 470
ANS: E PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
56. If the consumption function is C = 200 + 0.8Y, which of the following is true?
a. This economy’s consumption is 300 when income is 100.
b. When income increases by 100, consumption increases by 90.
c. This economy’s consumption is 200 when income is 0.
d. The marginal propensity to consume in this economy is .2.
e. When income increases by 100, consumption increases by 20.
ANS: C PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
57. If the consumption function is C = 1,000 + 0.87Y, then what is the marginal propensity to consume?
a. 1,000
b. 0.87
c. 0.13
d. 870
e. None of these
ANS: B PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
58. Which of the following consumption functions has a marginal propensity to consume equal to 0.95?
a. C = 95 + 0.87Y
b. C = 0.95 + 0.87Y
c. C = 1,000 + 0.05Y
d. C = 1,000 + 95Y
e. None of these
ANS: E PTS: 1 DIF: challenging
NAT: Understanding and applying economic models
60. When Tom’s income is $20,000, he spends $18,000 and when his income increases to $30,000, he
spends $23,000. His MPC is
a. 0.3.
b. 0.5.
c. 0.65.
d. 0.77.
e. 0.90.
ANS: B PTS: 1 DIF: moderate
NAT: Consumption spending during fluctuations in GDP
61. If two successive levels of disposable personal income are $160 and $190 billion, respectively, and if
the change in consumption spending is $20 billion between these two levels of disposable personal
income, then the MPC will equal
a. 0.50.
b. 0.67.
c. 0.80.
d. 0.20.
e. 1.50.
ANS: B PTS: 1 DIF: challenging
NAT: Consumption spending during fluctuations in GDP
67. T or F. The consumption function is a straight-line relationship between consumption and income.
68. T or F. The marginal propensity to consume is best defined as the change in consumption expenditure
caused by a one-unit increase in income.
69. T or F. When examining consumption behaviour at the household level, it does not make a difference
whether real household income or disposable income is used.
75. Define the marginal propensity to consume. Graphically, how is the marginal propensity to consume
shown?
ANS:
The MPC measures the change in consumption with respect to a change in aggregate income.
Graphically, it is the slope of the consumption function that shows the relationship between income
and consumption.
76. Does it make a difference whether disposable income is used instead of real GDP when working with
the relationship between aggregate consumption and aggregate income? Explain.
ANS:
At the aggregate level, it does not make a difference whether disposable income or real GDP is used.
This is because taxes and transfer payments are nearly proportional to income. Hence, disposable
income and real GDP are both linearly related to consumption.
ANS:
a. Consumption, saving, and taxes.
b. Note that YD = C + S. Substitute in for C to get YD = 100 + .75D + S or S = −100 +
.25YD.
Exhibit 7.4
78. Refer to the data in Exhibit 7.4.
a. What is the marginal propensity to consume?
b. If real GDP were $340 billion, what would consumption equal?
ANS:
a. The table shows that, for every $25 billion increase in real GDP, consumption increases
by $15 billion. The .
b. At $315 billion, consumption is $290 billion. If real GDP were $25 billion more, or $340
billion, consumption would be $15 billion more, or $305 billion.
Exhibit 7.5
79. Plot the consumption function based on the data in Exhibit 7.5. What is the marginal propensity to
consume? If the marginal propensity to consume changes to 0.85, show what happens to the
consumption function.
ANS:
The relationship between consumption and income is shown in figure I below. The MPC is 0.7. If the
MPC changes to 0.85, the relationship between income and consumption is shown in figure II. Notice
how the consumption function has pivoted up.
PTS: 1 DIF: moderate NAT: Consumption spending during fluctuations in GDP
84. T or F. Income depends on consumption, but consumption does not depend on income.
87. If adding net exports to C + I + G causes the expenditure line to shift up in a parallel way,
a. imports and exports are not sensitive to changes in income.
b. both exports and imports are sensitive to changes in income.
c. exports are sensitive to changes in income.
d. imports are sensitive to changes in income.
e. imports and exports have an uncertain effect on income.
ANS: A PTS: 1 DIF: moderate
NAT: Finding real GDP
92. Which of the following would not shift the expenditure line?
a. An increase in government spending to finance a war
b. An increase in investment
c. A decrease in net exports brought about by an appreciation of the dollar
d. All of these would shift the expenditures curve.
ANS: D PTS: 1 DIF: challenging
NAT: Finding real GDP
94. Which of the following will cause an upward shift of the expenditure line?
a. A decrease in wealth
b. A decrease in government purchases
c. A decrease in taxes
d. An increase in imports
e. An increase in saving
ANS: C PTS: 1 DIF: moderate
NAT: Finding real GDP
98. T or F. Changes in autonomous T, I, G, and X affect only the intercept of the expenditure line.
99. T or F. The expenditure line will shift if government spending increases, but not if it decreases.
100. T or F. Only changes in consumption spending will shift the expenditure line.
101. T or F. Changes in spending behaviour shift the expenditure line and help explain economic
fluctuations.
105. Which of the following best explains why the expenditure line intersects the 45-degree line?
a. The slopes of both lines are the same.
b. The slope of the expenditure line is greater than the slope of the 45-degree line.
c. The slope of the 45-degree line is greater than the slope of the expenditure line.
d. The slope of the expenditure line is greater than 1.
e. The slope of the expenditure line is negative.
ANS: C PTS: 1 DIF: challenging
NAT: Finding real GDP
107. Which of the following statements best describes what is meant by a spending balance?
a. People’s consumption is described by the consumption function.
b. Consumption and spending are the same, and people’s consumption is described by the
consumption function.
c. Income and output are the same.
d. Consumption and income are the same, and people’s consumption is described by the
consumption function.
e. There is no unplanned spending.
ANS: E PTS: 1 DIF: challenging
NAT: Finding real GDP
Exhibit 7.6
109. If output was at the level corresponding to point E in Exhibit 7.6, then
a. income would increase.
b. aggregate output would decrease.
c. it would be in equilibrium.
d. the marginal propensity to consume would decrease.
e. spending would decrease.
ANS: B PTS: 1 DIF: moderate
NAT: Finding real GDP
110. If spending was equal to the amount corresponding to point B in Exhibit 7.6,
a. aggregate output would increase.
b. aggregate output would decrease.
c. spending is too high, and the expenditure line will shift down.
d. the economy would be in equilibrium.
e. the marginal propensity to consume would increase.
ANS: A PTS: 1 DIF: moderate
NAT: Finding real GDP
111. Suppose the expenditure line is given by the equation E = 800 + .75Y, and output is equal to 3,000.
Which of the following is true?
a. There is an incentive for firms to increase output.
b. Spending is less than income.
c. Spending is equal to income.
d. The economy is in equilibrium.
e. There is too much output.
ANS: A PTS: 1 DIF: challenging
NAT: Finding real GDP
113. According to the table below, when the economy is at the point of spending balance, consumption
equals
a. 25.
b. 4.
c. 20.
d. 16.
e. 12.
ANS: D PTS: 1 DIF: moderate
NAT: Finding real GDP
117. T or F. When spending balance is achieved, the economy has reached a long-run equilibrium.
118. T or F. If spending is greater than output, a firm’s inventories will increase, and output will decrease.
119. T or F. Equilibrium output in the short run, as given by spending balance, can be above or below
potential GDP.
121. T or F. According to the spending balance model, an initial change (shift) in spending causes a change
in income, which causes further changes in spending and income.
ANS:
a. The 45-degree line identifies all points where spending is equal to output. These
represent the possible equilibrium points because, when planned spending is equal to
output, there is no incentive to increase or decrease production.
b. The expenditure line measures desired (planned) spending by the four groups for any
level of income. It is derived by adding up the four spending categories. It excludes
unplanned investment.
c. Spending balance is where the 45-degree line and the expenditure line intersect. At this
point, output is equal to desired spending, and there is no incentive for the firm to change
production. Aggregate unplanned inventories equal zero. At any other level of output,
spending will either be above or below output, and firms will either increase or decrease
production.
123. When does the slope of the expenditure line equal the MPC?
ANS:
The expenditure line is parallel to the consumption function when the consumption function is the only
component of aggregate expenditures that is sensitive to income. For simplicity, the other expenditures
are sometimes assumed to be constants. Hence, the slope of the expenditure line will have the same
slope as the consumption function, which is the MPC.
ANS:
a. If inventories are rising unexpectedly, spending by customers is less than output.
b. Sooner or later the firm will reduce output so that inventory will not keep growing.
c. If unplanned inventory changes are positive and significantly large for some period of
time, this indicates that firms will reduce output. This will also cause income and
spending to fall.
125. When spending is equal to output and the economy has reached spending balance, inventory
investment must equal zero. Please answer true or false, and explain.
ANS:
False. If spending is equal to output as given by spending balance, then there are no unintended
changes to inventory. Firms can still have planned increases or decreases in inventory.
b. Using the information in the table below, plot the line showing the relationship between
expenditure and income. What is the slope of this line?
c. Using the graphical approach and the information in the above table, show what happens
to the spending balance if government expenditures increase by 9.
d. Using the graphical approach and the information in the above table, show what happens
to the spending balance if the MPC increases to 0.9.
ANS:
a. As shown in the figure below, this line is the 45-degree line. The slope of the line is 1.
b. The figure below is a graph of the expenditure line. The slope of the line is equal to the
MPC, which is 0.7.
c. The increase in government expenditures causes the expenditure line to shift up from E1
to E2. The new spending balance is at 60 as opposed to 30.
d. The expenditure line pivots up from E1 to E2. The spending balance occurs at 60 instead
of 30.
PTS: 1 DIF: basic NAT: Finding real GDP
127. Suppose you are given the following information about the economy:
C = 200 + 0.75Y
I = 50
G = 250
X = 100
a. Find the aggregate expenditure function (the total amount of spending by the four
groups), and plot it on a graph with spending on the vertical axis and output on the
horizontal axis.
b. Suppose current output is 2,800. On your graph, identify this output level and the level of
spending associated with it.
c. Is Y = 2,800 the short-run equilibrium level of output? Please explain and demonstrate
graphically.
ANS:
a. E = C + I + G + X = 200 + 0.75Y + 50 + 250 + 100 = 600 + 0.75Y.
b. At Y = 2,800, E = 600 + 0.75(2,800) = 2,700.
c. The short-run level of equilibrium output is not 2,800. When Y = 2,800, spending is only
2,700. Firms will reduce output and spending will fall. Equilibrium output is 2,400.
129. Assume initially that Australia’s real GDP is equal to potential GDP. Explain carefully whether each
of the following would cause real GDP to rise above or fall below potential GDP.
a. Many of the people who grew up in the 1930s, because they grew up in the Great
Depression, have much higher rates of saving than the current generations. Suppose
many of these wealthy Depression-era people begin to die and leave their accumulated
wealth to their heirs.
b. The European economies experience a surge in growth as a result of the weak euro,
which has stimulated exports and hence production in the European countries.
ANS:
a. As people die and leave their wealth to their heirs, consumption spending will increase
and/or saving will fall. People will have more wealth to spend. The expenditure line will
shift upward, and Australia’s real GDP will rise above potential GDP.
b. As growth in the European economies surges, they will have more income to spend on
imported goods and services. Our exports will increase, and the expenditure line will
shift up. Australia’s real GDP will rise above potential GDP.
130. Describe what happens to Australia’s aggregate expenditure line in each of the following cases:
a. The government cuts capital gains taxes.
b. The European Union imposes a ban on Australian-produced dairy products.
c. A new law requires builders of new homes to pay a $5,000 tax.
d. Baby boomers begin to worry about retirement and increase their average propensity to
save.
ANS:
a. The decrease in taxes causes the expenditure line to shift up.
b. This ban causes net exports to decline. The expenditure line shifts down.
c. The excise tax causes a decline in residential investment. The expenditure line shifts
down.
d. The increase in the APS causes a parallel drop in MPC. The expenditure line shifts
down.
PTS: 1 DIF: moderate NAT: Finding real GDP
131. Sketch the 45-degree line and the expenditure line on a diagram. What determines the slope of each
line? Explain why the point of intersection is the only possible equilibrium point. Use this diagram to
show what happens to the level of income if government purchases decline.
ANS:
The slope of the expenditure line is the MPC. This shows the change in E (or C) for a given change in
income. The slope of the 45-degree line is 1. The point where the aggregate expenditure line intersects
the 45-degree line is referred to as the point of spending balance. The initial point of spending balance
is where the aggregate expenditure line E0 intersects the 45-degree line. Only at this point is desired
spending, as given by E, equal to output.
As shown in the diagram below, a decline in government purchases causes the aggregate expenditure
line to shift down in a parallel way to E1 from E0.
132. Suppose business executives become very pessimistic and reduce their investment spending. Sketch a
diagram that illustrates how this change in opinion affects real GDP.
ANS:
A pessimistic attitude by businesses causes investment spending to decline. The effect on aggregate
expenditure and income is illustrated in the diagram below.
PTS: 1 DIF: moderate NAT: Finding real GDP
133. Suppose most European economies are in a recession. How would you expect this to affect the
European demand for Australian goods? What happens to net exports? Sketch a diagram that
illustrates how this change in net exports affects Australia’s real GDP.
ANS:
The recession in Europe results in a decline in our net exports.
PTS: 1 DIF: moderate NAT: Finding real GDP
134. Suppose you read in the paper that government purchases will decrease by $50 billion. Next to the
article are three forecasting companies’ predictions of the effect the reduction in government purchases
will have on real GDP. The predictions are:
Firm A: There will be no other changes in spending, and real GDP will fall by $50 billion.
Firm B: There will be no other changes in spending, and real GDP will fall by $75 billion.
Firm C: Investment will increase by $50 billion, and real GDP will remain the same.
ANS:
You should not believe Firm A. This firm has ignored the effect on consumption of a fall in income
associated with the fall in government spending. You may believe Firm B or Firm C. You would need
to find out why one firm believes investment will increase and why the other firm does not. If there
were no other changes in spending, real GDP would fall by more than $50 billion. If investment rose
by $50 billion, this would exactly offset the fall in government purchases, and real GDP would not
change.
135. T or F. Most short-term forecasts are based on expected changes in aggregate demand.
138. All else being equal, if households choose to consume a lower share of GDP, then
a. people must be saving less.
b. people will consume less in the future.
c. there must have been an increase in GDP.
d. people will consume more in the future.
e. there must have been a decrease in GDP.
ANS: D PTS: 1 DIF: moderate
NAT: The consumption function
140. Suppose that the generation of people who lived through the Great Depression prefer to save a higher
fraction of their income than the baby-boom generation does. The baby boomers have tended to
consume more freely and go more into debt.
a. As those who lived through the Great Depression die, they are leaving their accumulated
wealth to their baby-boom children. Explain what effect this will have on the
consumption function.
b. As the baby boomers continue to spend freely on consumption, how might their spending
affect consumption expenditure of future generations?
ANS:
a. Wealth is redistributed from people who are thriftier to those who are less thrifty. When
less thrifty people experience increases in wealth, they tend to increase their
consumption as a percentage of their income by a larger amount than their parents, and
the aggregate consumption function will shift upwards.
b. If they spend so much that their debt continues to grow, future generations may be forced
to reduce consumption in the future, which would shift the consumption line down. Also,
if baby boomers consume rather than invest, less capital passes to future generations and
less consumption will be possible than if the saving and investment of the baby boomers
had been higher. The production possibilities curve shifts rightwards slower if the
consumption share at Y* is higher.
PTS: 1 DIF: challenging NAT: What about interest rates and other effects on
consumption?
141. Suppose businesses believe that, within a year, a new generation of computers will be developed that
will be more powerful than the current ones but cheaper to run. Assuming everything else held
constant, how will investment and AE be affected?
ANS:
Expenditures on computers will decline in this period since many firms will wait until next year to
acquire the better yet cheaper computer system.
142. The following table shows the relationship between income and consumption in an economy.
Assume that investment (I) is $5 billion, government expenditure (G) is $4 billion, and net exports (X)
are $1 billion.
a. What is the numerical value of the marginal propensity to consume?
b. Construct a table that is analogous to the one presented in the text for this economy.
What is the level of income at the point of spending balance?
c. Suppose the above problem is modified to include taxes. Suppose first that, at any level
of income, consumers must pay taxes equal to $3 billion. Find the new level of spending
balance by modifying the table. Hint: If consumers have to pay taxes, this is income that
they cannot use for consumption.
d. Graphically illustrate what happens to spending balance when the government increases
taxes by $3 million.
ANS:
a. The value of the marginal propensity to consume is 0.7.
c. To modify the table, you will need to subtract 3 from each level of consumption and each
level of AE. Spending balance is now at a level of 50.
d. See graph below. The expenditure line will shift down. The new spending balance is 40.
PTS: 1 DIF: moderate NAT: Determining real GDP through spending balance
Toolkit
145. Suppose you are given the following information about the economy:
C = 400 + 0.75Y
I = 250
G = 250
X = −100
ANS:
E = C + I + G + X = 400 + .75Y + 250 + 250 + (−100) = 800 + 0.75Y.
Setting E = Y results in Y = 3,200.