Chapter 3

Question 1

What is GDP composed by?

Answer 1

Consumption, Investment, Government Spending (and Exports and Imports if it’s an open market)
Z ≡ C + I + G + X - IM

Question 2

Consumption (C)

Answer 2

goods and services purchased by consumers. Largest component of GDP.

Question 3

Investment (I)

Answer 3

The sum of non-residential investment (the purchase by firms of new plants and machines) and residential investment (the purchase by people of new houses).

Question 4

Government spending (G)

Answer 4

purchases of goods and services by the federal, state and local governments. (Does not include government transfers like Medicare and Social security payments).

Question 5

Exports (X) and imports (IM)

Answer 5

X - IM = net exports/trade balance. If exports exceed imports, the country is said to run a trade surplus. If exports are les than imports the country is said to run a trade deficit.

Question 6

Inventory investment

Answer 6

The difference between goods produced and goods sold in a given year (the difference between production and sales) is called inventory investment.

Question 7

What do we assume in our composition of GDP?

Answer 7

• All firms produce the same good which then can be used by consumers for consumption, by firms for investment or by the government
• The firms are willing to supply any amount of the good at a given price level P
• The economy is closed —> makes X - IM disappear, giving us the demand function: 
Z ≡ C + I + G

Question 8

What is disposable income?

Answer 8

• YD, the income that remains with the consumer once he has paid taxes and received gov. stuff.
• When the disposable income goes up, people spend more, when it goes down, people spend less.

Question 9

What is c1?

Answer 9

c1 is the propensity to consume. Gives the effect an additional dollar of disposable income has on consumption.

• A natural restriction is that it’s positive (people are more likely to consume if they get an increase in disposable income)
• Another is that it’s less than 1, since people are unlikely to spend all their income (they will save some)

Question 10

What is c0?

Answer 10

c0 is what people would consume if their disposable income in the current year was 0.

Question 11

How can people spend if they have 0 income?

Answer 11

They dis-save. They consume either by selling some of their assets or by borrowing.

Question 12

What does changes in c0 imply?

Answer 12

• Changes in c0 reflect changes in consumption for a given level of disposable income. Increases in c0 reflect an increase in consumption given income, and the reverse.
• There are many reasons why people may decide to consume more or less, given their disposable income. They may find it easier/harder to borrow, or may be more/less optimistic about the future.

Question 13

What is the extended consumption function?

Answer 13

C = c0 + c1(Y - T)

Question 14

What is investment?

Answer 14

An exogenous variable. Taken as given.

I = ī

Question 15

Endogenous variables

Answer 15

Variables that depend on other variables in the model.

Question 16

Exogenous variables

Answer 16

Variables that are determined outside the model and that we take as given.

Question 17

What is government spending?

Answer 17

Together with taxes (T), G describes fiscal policy.
Exogenous variables, because:
- Governments don’t behave with the same regularity as consumers or firms, so there’s no reliable rule we can use to write for G and T.
- Makes it possible to evaluate different scenarios depending on how the government for ex. Set taxes.

Question 18

Equilibrium condition in the goods market

Answer 18

Y = c0 + c1(Y - T) + ī + G

In equilibrium, production (Y) = demand (Z). Demand in turn depends on income, Y, which itself = production. Production and income are identically equal.

Question 19

Autonomous spending

Answer 19

This is the part of the demand for goods that doesn’t depend on output. We can almost be sure that autonomous spending always will be positive, because c0 and ī are positive. And if the government is running a balanced budget (G = T), and the propensity to consume is less than 1, then (G - c1T) is positive, and so is autonomous spending. Only if the government were running a very large budget surplus - if taxes were much larger than government spending - could autonomous spending be negative. Although this case can be ignored here.

Question 20

Multiplier

Answer 20

Because the propensity to consume (c1) is between 0 and 1, the multiplier is a number greater than 1. The closer c1 is to 1, the larger the multiplier. 


So if the government runs a balanced budget (T = G) then:
(G - c1T) = (T - c1T) = (1- c1)T > 0

Question 21

What does the multiplier imply?

Answer 21

That any change in autonomous spending - from a change in investment, to a change in government spending or taxes - will have the same qualitative effect: it will change output by more than its direct effect on autonomous spending.

Question 22

Where does the multiplier effect come from?

Answer 22

An increase in c0 increases demand. The increase in demand then leads to an increase in production. The increase in production leads to an increase in income. The increase in income further increases consumption, which further increases demand, and so on.

Question 23

What happens when c0 increases?

Answer 23

An increase in c0 increases demand. The increase in demand then leads to an increase in production. The increase in production leads to an increase in income. The increase in income further increases consumption, which further increases demand, and so on.

Question 24

How is propensity to consume related to the multiplier?

Answer 24

• The size of the multiplier is directly related to the value of the propensity to consume.
• The higher the propensity to consume, the higher the multiplier.

Question 25

How is private saving defined?

Answer 25

S ≡ YD - C —> S ≡ Y - T - C

Question 26

How is public saving defined?

Answer 26

T - G

Question 27

Budget surplus

Answer 27

If taxes exceeds government spending the government is running a budget surplus.

Question 28

Budget deficit

Answer 28

If taxes are less than government spending the government is running a budget deficit.

Question 29

Prove that investment = saving

Answer 29

Y = C + I + G Y - T - C = I + G - T S = I + G - T I = S + (T - G)

Question 30

Why are saving and consumption decisions the same?

Answer 30

Note that consumption and saving decisions are one and the same: given the disposable income, once consumers have chosen consumption, their saving is determined and vice versa. This implies that private saving is given by: S = Y - T - C = Y - T - c0 - c1(Y - T) Rearranging gives us: S = -c0 + (1 - c1)(Y - T)

Question 31

Propensity to save

Answer 31

So in the same way we called c1 the propensity to consume, we can call (1 - c1) the propensity to save. Since c1 is between 1 and 0 (1 - c1) is also. Private saving increases with disposable income, but by less than one dollar for each additional dollar of disposable income.