Theory is a possible explanation of observable phenomena. Explain.

- Begins with assumptions, proceeds through logical reasoning to conclusions

- Economists have only historical data: Often insufficient to decide on competing theories

Macroeconomic theory often based on model. Explain.

Macroeconomic theory often based on model

- System of mathematical equations

- May also be expressed diagrammatically or verbally

Explain Exogenous and Endogenou variables

Exogenous variables – determined externally ie Temperature of gas

Endogenous variables – explained by theory ie Volume and Preassure

Volume and Preassure depends on Temperature of gas

A model is a complete model when it can be used to predict what the values of the ___ will be when the value of the ___ are known

endogenous variables;

exogenous variables

Price level considered exogenous in short run for a given period, explain.

Price level considered exogenous in short run for a given period

- Determined by previous events that have already taken place

- Inflation rate considered endogenous but change in inflation rate will be reflected in next period’s price level

- Price-level assumption at heart of Keynesian Revolution (1936)

Disposable Income = ?

Disposable Income (Yd) = Income (I) – Taxes + Transfers

Define the consumption function.

The relationship between the consumption and income is called the consumption function. Empirical evidence suggests that households increase their consumption as their income increases but not as much as their income.

Empirical studies (following on from Keynes’s General Theory) have found that:

1. Households with relatively low income will save proportionally less (or even dis-save) than households with a proportionally higher income

2. Over long periods as the living standards in a society increase the relationship between consumption and disposable income appears roughly proportional. Consequently, the proportion of disposable income saved has remained fairly stable over long periods of time.

3. While the long-run relationship has been historically stable, the relationship between short-term changes in income and changes in consumption is less predictable. In the short-run the change in consumption tends to lag the change in income.

Define:

Marginal Propensity to Consume (MPC)

Average Propensity to Consume (APC)

Marginal Propensity to Save (MPS)

A ___ indicates that the amount consumed is ___, the direction of change dependent on whether the consumption function shifts upward or downward. A shift can be caused by a change in ___, which leads to a change in the whole function.

A ___ indicates the changes in consumption that are ___. A movement along the consumption function is caused by only ___.

shift in the consumption function curve;

different at each level of income;

factors other than the income;

movement along the consumption function curve;

a consequence of the changes in income;

changes in income (cet. par.)

Explain shifts of demand curve and movemnets along the demand curve.

From the microe-conomics modules, the appropriate analogy is a movement along a given demand curve caused by changes in price, and shifts in that curve that are the consequence of changes in:

(a) incomes,

(b) the price of complementary or substitute goods,

(c) changes in tastes.

**A shift in the demand curve changes the quantity demanded for any given price**. **A movement along the demand curve shows the changes in the amount demanded, which are caused by changes in price. **

**Similarly, a shift in the consumption function curve indicates that the amount consumed is different at each level of income, the direction of the change depending upon whether the consumption function schedule shifts upwards or downwards. **

**A movement along a given consumption function curve indicates the changes in consumption that are a consequence of changes in income.**

Explain the Solution to the Simple Model Questions.

**Y = C + I**

where national income (Y) is determined by the sum of consumption expenditures and investment expenditures and C + I = aggregate demand or aggregate expenditure (E).

**C = bYd**

where consumption is a function of income. The relationship is proportional at all levels of income, so that APC = MPC = b,

**I = I0**

where the level of investment is fixed exogenously or autonomously, i.e. its value is determined outside the economic system.

Where the aggregate demand (expenditure) function lies above the 45deg line aggregate demand is more than the national income, below it is less. At aggregate demand = national income, I=S and the model is in equilibrium.

Explain the multiplier.

An autonomous increase in aggregate demand (e.g. through increase of investment) has a multiplier effect in the national output and income.

Increase in national output = increase in aggregate demand x multiplier

Not confined to autonomous change in investment expenditure

For the multiplier process to work it’s way to completion, there has to be

1. sufficient unemployment. If the economy were to operate at full employment any autonomous increase in demand would result in inflation as the output Y has reached the potential output. The remaining demand creates and inflationary gap.

2. an MPC between 0 and 1. In the real world calculating the multiplier is very difficult. It therefore is not easy to guide the economy to full employment.

- Imported goods have multiplier effect in foreign nations

- If increased demand causes demand for money (interest rates) to increase, multiplier may be negative

Major differences between natural scientists and economists are

I. natural scientists can test and retest hypotheses in a laboratory while economists have to rely on histori-cal data

II. natural scientists do not need theories for finding explanations of natural phenomenan; they deal only with facts. Economists need theories since facts do not always exist

Which of the following is correct?

A. I only

B. II only

C. Both I and II

D. Neither I nor II

The correct answer is A. Natural scientists are often able to repeat experiments in laboratories thus testing and re-testing hypotheses e.g. what happens when you add hydrochloric acid to different metals. Natural scientists can create ‘ceteris paribus’ conditions (remember cet. par. from micro) much more readily than can economists who have to deal with the real world where things change continuously. Thus I is correct. A theory is nothing more than a possible explanation of observable phenomena; every theory begins with assumptions and proceeds through logical reasoning to reach conclusions. Many theories can then be tested empirically. All scientists, natural and social including economic, use theories. Thus II is incorrect.

D represents our household’s demand for steak in a week when there are no guests; it shifts to the right D* when guests are coming, the shift being dependent on the number of guests

In this example

I. the number of guests is an exogenous variable

II. price of steak is an exogenous variable

III. quantity of steak demanded is an endogenous variable

Which of the following is correct?

A. I only

B. I and III only

C. III only

D. I, II and III

The correct answer is B. A given demand curve is a hypothetical relationship indicating the quantity that would be purchased for each and every price ceteris paribus. Thus price and quantity are explained by the curve (model). Thus III is correct and II is incorrect. The number of guests coming to dinner is not determined by the demand curve but by outside factors. Thus the number of guests is an exogenous variable; thus I is correct.

If consumption (C) is a positive function of disposable income (Yd) which of the following would cause consumption expenditure to increase in the absence of any offsetting factors. A decrease in

A. income before tax

B. tax upon income

C. transfer payments

D. income after tax

The correct answer is B. From the statement, consumption increases as disposable income increases. Disposable income will increase as transfers increases and as taxes decrease. Thus A, C and D are incorrect.

Which of the following is correct?

I. When Y = 0, C = a

II. When Y = 0, savings = −a

III. When Y = Y1, savings = 0

A. I only

B. II only

C. III only

D. I, II and III

In the figure

I. The MPC is constant

II. The APC is constant

III. Y = C + S only for income levels > Y1

Which of the following is correct?

A. I only

B. I and II only

C. II and III only

D. I, II and III

An electronics company invested $10m in new factories, i.e. caused an initial increase in income ΔY of $10m. Assuming there are sufficient unemployed resources to allow the complete multiplier process to occur, which of the following would the value of the marginal propensity to consume have to be for the total increase in income to be 20 million?

A. 0

B. 0.5

C. 1.0

D. 20

Which of the following numbers (rounded to the nearest whole number) should replace the question marks in Row 4 ΔC and Row 5 ΔY?

A. 48 and 32

B. 48 and 40

C. 51 and 48

D. 51 and 41

Which of the following will be the total change in C and Y when the multiplier processes are complete?

A. 236 and 336

B. 400 and 500

C. 636 and 836

D. 800 and 1000

The correct answer is B. Since the value of the MPC is .8 the value of the multiplier will be 5. Thus the total change in income, ΔY, will be ��I × 5 = 100 × 5 = 500 Of the 500, 100 is the increase in investment. Thus the increase in consumption will be 500 − 100 = 400.

If a consumption function is linear and the values of the APC and MPC are equal which of the following is correct?

A. The consumption function goes through the origin

B. There are unemployed resources in the economy

C. The value of the multiplier increases as Y increases

D. The value of the multiplier decreases as Y increases

In economic models the variables whose values are determined

I. within the model are known as endogenous variables

II. outside the model are known as exogenous variables

Which of the following is correct?

A. I only

B. II only

C. Both I and II

D. Neither I nor II

he correct answer is C. This is a question about definitions. As a mnemonic try this:

outside = ex

inside = en

Both I and II are true.

The correct answer is D. The equation explains Pt + 1. Let Pt= 100 and the inflation rate = 6%, i.e. .06. Then Pt + 1= 100(1 + 0.06) = 106 . Thus Pt + 1 is endogenous, Pt and INF exogenous. Thus A, B and C are wrong. If the inflation rate is negative e.g. −3% then Pt + 1= 100(1 − 0.3) = 97 which is < 100.

Had the consumption function C= bY been indistinguishable from the 45% line which of the following would be true?

A. The multiplier would be zero

B. Savings and consumption would be equal

C. The marginal and average propensity to consume would be equal

D. Consumption would not increase as rapidly as income

In the diagram for the consumption function C = bY

I. The marginal propensity to consume = b

II. The marginal propensity to consume = △C/△Y

III. The average propensity to consume = C/Y = b

Which of the following is correct?

A. I only

B. I and III only

C. II and III only

D. I, II and III

If national income (Y) is measured along the horizontal axis and investment expenditure (I) on the vertical axis and if the investment function is a horizontal line above the Y axis, which of the following is correct?

A. I is an endogenous variable

B. ΔI/ΔY = 0

C. When Y = 0, I = 0

D. When Y increases, I increases but not by as much as Y

The correct answer is B. By being a horizontal line, I is independent of Y, thus C and D are incorrect. The value of I is determined outside the model (diagram), therefore I is exogenous; thus A is incorrect. Since I ≠ f(Y) then ΔI/ΔY = 0.

The equation of a consumption function is C= 20 + .8Yd. It can be concluded that

I. C will exactly equal Yd when Yd= 100

II. the marginal propensity to consume (MPC) is constant

III. the average propensity to consume (APC) is constant

Which of the following is correct?

A. I only

B. I and II only

C. II only

D. I, II and III

In a certain community households spend 90¢ out of each additional 1$ of income. If the local government, wishing to reduce the high local unemployment rate, invested $500 000 in local schools and parks which of the following is the amount by which total income in the area would increase assuming all multiplier rounds occurred within the area?

A. $500 000

B. $1 000 000

C. $1 500 000

D. $5 000 000.

If the equation of Aggregate Demand1 is equal to a+ .75Y, which of the following is the autonomous increase in investment required to take the economy from Y1 to YF?

A. 750

B. 1000

C. 2000

D. 3000

If the autonomous increase in investment took the aggregate demand curve to Aggregate Demand2, which of the following would happen?

A. Some resources would become unemployed

B. Inflation would occur

C. Potential output would exceed aggregate demand

D. The value of the MPC would increase

The correct answer is B. Had aggregate demand intersected the 45/Q line at the ‘kink’, Y would equal Q, the economy would be operating at capacity/full employment without inflation. For level of demand Aggregate Demand2 all resources will remain employed but aggregate demand will exceed Q and inflation will occur. Thus A and C are wrong and B is correct. Assuming Aggregate Demand2 is parallel to Aggregate Demand1, the slope of the consumption function and consequently the value of the MPC will be unaltered. Thus D is incorrect.

Which of the following is correct? The marginal propensity to consume out of disposable income

A. is sometimes positive and sometimes negative.

B. varies between 0.20 and 1.25.

C. cannot be calculated from the data provided.

D. is 0.8.

The correct answer is D. The marginal propensity to consume (MPC) is calculated by dividing the change in consumption by the accompanying change in disposable income, i.e. ΔC/ΔY. As disposable income increases, the accompanying changes in consumption and the marginal propensity to consume are as follows:

Which of the following is correct? The average propensity to consume

A. is constant.

B. increases as disposable income increases.

C. decreases as disposable income increases.

D. has a value less than 1.

The correct answer is C. The average propensity to consume of disposable income is found by dividing consumption expenditure by disposable income.

At the lowest level, the value of APC exceeds 1 but declines to a value of 0.95 as

income increases.

Which of the following is correct? A straight-line consumption function with a positive intercept (cuts the vertical axis above zero) and a slope of less than 1 (slopes upward to the right at less than 45° angle) would be one for which

A. the average propensity to consume increases with the level of income.

B. the average propensity to consume is constant for all levels of income.

C. the marginal propensity to save is positive at all levels of income.

D. the average propensity to save is positive at all levels of income.

The correct answer is C. Figure A2.15 represents the consumption function described and the savings function derived from the consumption function. Consumption increases at a lower rate than income; as a result the average propensi-ty to consume, C/Y, falls as income rises. Thus, responses A and B are incorrect. For income levels less than y1, consumption exceeds income, so that dissaving takes place. Thus the average propensity to save is negative for income levels less than y1, is equal to zero at y1, and is positive thereafter. Thus response D is incorrect. The marginal propensity to save, S/Y, is given by the slope of the savings function and equals 1 − MPC, since MPC + MPS = 1. Like MPC, MPS is constant and positive for all levels of income.

For a certain economy, the consumption function is C = 15 + 0.75 Yd

(where Yd = disposable income). In addition,

I. saving = 10 when disposable income = 100.

II. consumption = 240 when disposable income = 300.

III. a level of disposable income exists for which consumption = saving.

Which of the following is correct?

A. I only.

B. I and II only.

C. II and III only.

D. III only.

The correct answer is B. If C = 15 + 0.75Yd, then when Yd = 100

C

Which of the following explains why an increase in investment can have a ‘multiplier’

effect on national income in an economy which is operating well below full-employment output? Investment spending

A. raises potential GNP.

B. yields income to resource owners, who in turn spend part of that income on consumption and hence income increases again.

C. increases the marginal propensity to consume, which increases income flows.

D. enters the flow of economic activity more quickly than any other type of

spending.

The correct answer is B. In an economy operating below full employment, i.e. with unemployed factors of production, increased investment creates employment and

income for previously unemployed factors of production. Factor incomes rise and this, in turn, will result in higher consumption. Higher consumption will create

employment and income in a further range of activities, and lead to another round of additional consumption, and so on. The eventual increase in aggregate demand will be some multiple of the initial increase in demand.

If the marginal propensity to consume were zero, which of the following could result from a decline in investment demand?

A. A reduction of equal value in the equilibrium level of national income.

B. No change in the equilibrium level of national income.

C. An unending downward spiral of national income.

D. A compensating increase in the level of consumption expenditure.

The correct answer is A. If the marginal propensity to consume were zero, then the multiplier would be 1. Since there would be no induced expenditure effect, any decline in investment expenditure would therefore not reduce consumption. The fall in aggregate demand would be restricted to the initial decline in investment demand without any secondary effects.

Which of the following is correct? The consumption function shows

A. that consumption depends primarily on the level of business investment.

B. that households consume more when interest rates are low.

C. that the marginal propensity to consume increases with national income.

D. the amounts households plan to consume at various possible levels of income.

The correct answer is D. The consumption function is a schedule showing the level of planned consumption at each possible level of income.

In constructing economic models

I. the value of an exogenous variable is determined by the endogenous variables.

II. exogenous variables affect the values of the endogenous variables.

Which of the following is correct?

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

The correct answer is B. In economic models the values of some variables are assumed to be determined by external events, i.e. external to the model. Thesevariables are known as exogenous variables. Endogenous variables are affected by exogenous variables but the reverse is not true.

C = 50 + 0.5Y

I = 100

Y ≡ C + I

Which of the following is correct?

A. Only I is an exogenous variable.

B. Only I is an endogenous variable.

C. Only C and I are exogenous variables.

D. Only Y is an endogenous variable.

The correct answer is A. The value of C depends upon Y, and therefore C is an endogenous variable. The value of Y depends upon both C and I, and therefore Y is an endogenous variable. The value of I is always 100, independent of the values of C and Y, therefore I is an exogenous variable.

C = 50 + 0.5Y

I = 100

Y ≡ C + I

What is the equilibrium value of Y?

A. 50.

B. 100.

C. 250.

D. 300.

What would be the equilibrium value of C if I were to increase from 100 to 200?

A. 200.

B. 300.

C. 400.

D. 500.

What is the change in the value of the investment multiplier when I changes from 100 to 200?

A. It remains constant at 2.

B. It increases from 2 to 3.

C. It doubles from 2 to 4.

D. It remains constant at 0.5.

If I became zero, what would the equilibrium value of C be?

A. 0.

B. 0.5Y.

C. 50.

D. 100.

The consumption function in Figure 14.8 relates household consumption expenditure (C) to disposable income (Yd). It shows

I. a constant marginal propensity to consume (MPC).

II. a constant average propensity to consume (APC).

III. dissavings for Yd < $4000.

Which of the following is correct?

A. I only.

B. I and III only.

C. II only.

D. I, II and III.

The correct answer is B. The value of MPC is given by the slope of the consumption function. Since C is a straight line in Figure 14.8, the MPC must be constant. The APC is found by dividing C by Yd. Since C has a positive intercept equal to 2000, C/Yd must decline as Y increases. Where C intersects the 45° line, C = Yd and consequently savings (Yd –C) = 0. To the left of the intersection point S < 0 (dissaving); to the right of the intersection C < Y and therefore S > 0 (positive saving).