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W H AT I S E C O N O M I C S ? Answers to the Review Quizzes 191 1 EXPENDITURE MULTIPLIERS** Page 307 (page 715 in Economics) Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP Both increase when real GDP increases Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save The marginal propensity to consume is the proportion of an increase in disposable income that is consumed In terms of a formula, the marginal propensity to consume, or MPC, can be calculated as C/YD, where means “change in.” The marginal propensity to save is the proportion of an increase in disposable income that is saved In terms of a formula, the marginal propensity to save, or MPS, can be calculated as S/YD How we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import? The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP Page 311 (page 719 in Economics) What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure? Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP How does equilibrium expenditure come about? What adjusts to achieve equilibrium? Equilibrium expenditure results from adjustments in real GDP For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories 191 192 are below their targets In response, firms increase production to meet their inventory targets, As production increases, real GDP increases The increase in real GDP increases aggregate planned expenditure but by less than the increase in real GDP Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels The increase in production increases real GDP If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels The decrease in production decreases real GDP Page 316 (page 724 in Economics) What is the multiplier? What does it determine? Why does it matter? The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP A change in autonomous expenditure changes real GDP by an amount determined by the multiplier The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP How the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier? The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger How fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle Page 321 (page 729 in Economics) How does a change in the price level influence the AE curve and the AD curve? A change in the price level shifts the AE curve and creates a movement along the AD curve If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why? A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve The AE curve shifts by an amount equal to the change in autonomous expenditure The multiplier determines the magnitude of 192 W H AT I S E C O N O M I C S ? 193 the shift in the AD curve The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the short run, an increase in aggregate expenditure increases real GDP However, the increase in real GDP is less than the increase in aggregate demand because the price level rises The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change The change in real GDP—zero—is less than the change in aggregate demand The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP Page 327 (page 735 in Economics) In an economy, autonomous consumption expenditure is $50 billion, investment is $200 billion, and government expenditure is $250 billion The marginal propensity to consume is 0.7 and net taxes are $250 billion Exports are $500 billion and imports are $450 billion Assume that net taxes and imports are autonomous and the price level is fixed a What is the consumption function? The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same In this case the consumption function is C = 50 + 0.7(Y – 250) where the “50” is $50 billion and the “250” is $250 billion b What is the equation of the AE curve? The equation of the AE curve is AE = 375 + 0.7Y, where Y is real GDP and the 375 is $375 billion Aggregate planned expenditure is the sum of consumption expenditure, investment, government purchases, and net exports Using the symbol AE for aggregate planned expenditure, aggregate planned expenditure is AE = 50 + 0.7(Y – 250) + 200 +250+ 50 AE = 50 + 0.7Y – 175 + 200 + 250 + 50 AE = 375 + 0.7Y c Calculate equilibrium expenditure Equilibrium expenditure is $1,250 billion Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP That is, AE = 375 + 0.7Y and AE = Y Solving these two equations for Y gives equilibrium expenditure of $1,250 billion d Calculate the multiplier The multiplier equals 1/(1 the slope of the AE curve) The equation of the AE curve tells us that the slope of the AE curve is 0.7 So the multiplier is 1/(1 0.7), which is 3.333 193 194 e If investment decreases to $150 billion, what is the change in equilibrium expenditure? Equilibrium real expenditure decreases by $166.67 billion From part d the multiplier is 3.333 The change in equilibrium expenditure equals the change in investment, $50 billion, multiplied by 3.333 f Describe the process in part (e) that moves the economy to its new equilibrium expenditure When investment decreases by $50 billion, aggregate planned expenditure is less than real GDP Firms find that their inventories are accumulating above target levels As a result, they decrease production to reduce inventories Real GDP decreases The decrease in real GDP decreases disposable income so that consumption expenditure falls In turn, the decrease in consumption expenditure leads to a further decrease in aggregate planned expenditure Real GDP still exceeds aggregate planned expenditure though by less than was initially the case Nonetheless unwanted inventories are still accumulating and firms continue to cut production, further reducing real GDP This process continues until eventually real GDP will decrease enough to equal aggregate planned expenditure 194 Answers to the Study Plan Problems and Applications 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 11.1 to work Problems and Figure 11.1 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 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 a What is aggregate planned expenditure when real GDP is $6 billion? Figure 11.1 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 E X P E N D I T U R E M U LT I P L I E R S 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 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 and 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 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 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 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 to 13 Suppose that the economy is at full employment, the price level is 100, and the multiplier is Investment increases by $100 billion What is the change in equilibrium expenditure if the price level remains at 100? The initial change in equilibrium expenditure is $200 The initial effect of the increase in investment increases equilibrium expenditure by the change in investment times the multiplier The multiplier is and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion 141 142 CHAPTER 11 10.a What is the immediate change in the quantity of real GDP demanded? The quantity of real GDP demanded increases by $200 billion The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier The multiplier is and the change in investment is $100 billion, so the aggregate demand curve shifts rightward by $200 billion b In the short run, does real GDP increase 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 increases by less than $200 billion Real GDP is determined at the intersection of the AD curve and the SAS curve In the short run, the price level will rise and real GDP will increase but by an amount less than the shift of the AD curve 11 In the short run, does the price level remain at 100? Explain why or why not In the short run, the price level rises Real GDP is determined at the intersection of the AD curve and the SAS curve In the short run, the increase in aggregate demand means that the price level will rise as the economy moves along its upward-sloping SAS curve 12.a In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded? In the long run, real GDP equals potential GDP, so real GDP does not increase Real GDP is determined at the intersection of the AD curve and the SAS curve After the initial increase in investment, money wages increase, the SAS curve shifts leftward, and in the long run, real GDP moves back to potential GDP b Explain how the price level changes in the long run Real GDP is determined at the intersection of the AD curve and the SAS curve In the long run, money wages increase so the SAS curve shifts leftward, raising the price level by more than it rose in the short run 13 Are the values of the multipliers in the short run and the long run larger or smaller than 2? The multiplier in the short run is less than the multiplier of because the short-run increase in real GDP is less than $200 billion The long-run multiplier is even smaller It equals zero 14 Use the data in the Worked Problem on p 325 (page 737 in Economics) Calculate the change in equilibrium expenditure when investment decreases by $150 billion The multiplier equals Consequently the change in equilibrium expenditure equals (4) × (−$150 billion), or a decrease of $600 billion E X P E N D I T U R E M U LT I P L I E R S Answers to Additional Problems and Applications Use the following data to work Problems 15 and 16 You are given the information in the table about the economy of Australia 15 Calculate the marginal propensity to save The marginal propensity to save is the fraction of a change in disposable income that is saved In Australia, when disposable income increases by $100 billion per year, saving increases by $25 billion per year The marginal propensity to save is $25 billion ÷ $100 billion, which is 0.25 16 Disposable income Saving (billions of dollars per year) 0 100 25 200 50 300 75 400 100 Calculate consumption at each level of disposable income Calculate the marginal propensity to consume The table to the right shows Australia’s consumption expenditure schedule Consumption expenditure equals disposable income minus saving For each increase in disposable income of $100 billion, consumption expenditure increases by $75 billion The marginal propensity to consume is 0.75 The marginal propensity to consume plus the marginal propensity to save equals Because the marginal propensity to save equals 0.25, the marginal propensity to consume equals 0.75 Disposable income Consumptio n expenditure (billions of dollars per year) 0 100 75 200 150 300 225 400 300 Use the following news clip to work Problems 17 to 19 Americans $2.4 trillion Poorer The Federal Reserve reported that household wealth decreased by $2.4 trillion or $21,000 per household in the third quarter of 2011 This drop is the steepest since 2008 and the second consecutive quarterly drop Foreclosures lowered household debt slightly but credit card debt increased Many households are struggling to buy the essentials and spending on food has decreased Separately, the Bureau of Economic Analysis reported that consumption expenditure increased by $39 billion in the third quarter of 2011 Sources: The New American, December 11, 2011 and the Bureau of Economic Analysis 143 144 CHAPTER 11 17 Explain and draw a graph to illustrate how a fall in household wealth would be expected to influence the consumption function and saving function Figure 11.2a shows the effect of a decrease in wealth on the consumption function and Figure 11.2b shows the effect on the saving function Consumption expenditure decreases so the consumption function shifts downward from CF0 to CF1 while saving increases so the saving function shifts upward from SF0 to SF1 18 What factors might explain the actual changes in consumption expenditure and wealth that occurred in the third quarter of 2011? According to the article, consumption increased At least two other factors could explain the discrepancy between the “predicted” decrease in consumption in part a and the increase that actually occurred First, disposable income might have increased This change would lead to a movement upward along the (downwardshifted) consumption function so that consumption expenditure increased Alternatively people’s expected future incomes might have risen The upward revision in expected future income would lead to an upward shift of the consumption function which would offset the fall from the decrease in wealth 19 Draw a graph of a consumption function and show at what points consumers were actually operating in the second and third quarters Make any necessary assumptions and explain your answer Regardless of any increase in future expected income, it is likely the case that the decrease in wealth led to a net downward shift of the consumption function because the decrease in wealth was so large In Figure 11.2a the consumption function shifts downward from CF0 to CF1 Equally likely, however, disposable income increased So the economy moves from disposable income of $10.5 trillion and consuming at point A on consumption function CF0 to disposable income of $11.0 trillion and consuming at point B on consumption function CF1 E X P E N D I T U R E M U LT I P L I E R S A A B C D E F B Y 100 200 300 400 500 600 C C 110 170 230 290 350 410 D I 50 50 50 50 50 50 E G 60 60 60 60 60 60 F X 60 60 60 60 60 60 G M 15 30 45 60 75 90 Use the spreadsheet above, which lists real GDP (Y ) and the components of aggregate planned expenditure in billions of dollars, to work Problems 20 and 21 20 Calculate autonomous expenditure Calculate the marginal propensity to consume Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero Because the spreadsheet does not list GDP of zero, we must extrapolate to calculate the value of consumption expenditure and imports when GDP equals zero From the spreadsheet, consumption expenditure falls by $60 billion for every $100 billion decrease in GDP So when GDP equals zero, autonomous consumption expenditure is $50 billion Similarly, from the spreadsheet, imports decrease by $15 billion for every $100 billion decrease in GDP So when GDP equals zero, imports equal zero Autonomous expenditure is $50 billion (consumption expenditure) plus $50 billion (investment) plus $60 billion (government expenditure) plus $60 billion (exports), which equals $220 billion The marginal propensity to consume is 0.6 When income increases from $100 billion to $200 billion, consumption expenditure increases from $110 billion to $170 billion A $100 billion increase in GDP increases consumption expenditure by $60 billion So the marginal propensity to consume is $60 billion ÷ $100 billion, which is 0.6 145 146 CHAPTER 11 21.a What is aggregate planned expenditure when real GDP is $200 billion? Aggregate planned expenditure is $310 billion Aggregate planned expenditure is the sum of consumption expenditure ($170 billion) plus planned investment ($50 billion) plus government expenditure ($60 billion) plus exports ($60 billion) minus imports ($30 billion), which is $310 billion b If real GDP is $200 billion, explain the process that moves the economy toward equilibrium expenditure Inventories are decreasing so that the unplanned inventory change is negative When real GDP is $200 billion, aggregate planned expenditure is $310 billion Because aggregate planned expenditure exceeds real GDP, firms sell all that they produce and even more so that inventories are decreasing Firms then increase their production, to restore their inventories, and real GDP increases c If real GDP is $500 billion, explain the process that moves the economy toward equilibrium expenditure Firms are accumulating inventories so that the unplanned inventory change is positive When real GDP is $500 billion, aggregate planned expenditure is $445 billion Firms cannot sell all that they produce so that unplanned inventories increase Firms respond by decreasing their production, to lower their inventories, and real GDP decreases 22 Maruti Looks to Job, Production Cuts as Sales Decline As a result of slower economic growth and higher loan rates, local sales of Maruti Suzuki India Limited fell 7.8 percent in June from last year Consequently, the largest car maker in India has asked as many as 450 contract workers to go on “long leave”, or leave without pay, as an effort to cut production and reduce inventory levels at its dealerships Source: Mint, July 9, 2013 Explain how a rise in unplanned inventory causes firms to change their production A fall in demand or sales leads to piling up of inventories Inventories are part of investment If the rise in inventory is unplanned, firms will be forced to cut production in order to avoid further piling up of stocks, which then decreases aggregate expenditure and real GDP In the news clip, a rise in unplanned inventories depresses the firm’s production 23 In India, Focus Shifts To Deploying Fiscal Stimulus In an attempt to stimulate the economy, the Union Government announced a $23.9 billion increase in its planned expenditure in the annual budget Source: CNBC, March 19, 2015 If the slope of the AE curve is 0.6, calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged The increase in government expenditure will have a multiplier effect on aggregate expenditure and real GDP The multiplier equals 1/(1 – slope of AE curve) The slope of the AE curve is 0.6 so the multiplier is 1/(1 – 0.6), which is 2.5 With this multiplier, the $23.9 billion increase in planned government expenditure increases aggregate expenditure by 2.5 × $23.9 billion, or $59.75 billion In the short run, when the price level is constant, real GDP increases by the same amount, $59.75 billion E X P E N D I T U R E M U LT I P L I E R S 24 Obama’s Economic Recovery Plan President Obama's proposal to jolt a listless recovery with $180 billion worth of tax breaks and transportation projects left economists largely unimpressed Tuesday Source: USA Today, September 10, 2010 If taxes fall by $90 billion and the spending on transport projects increases by $90 billion, which component of Obama’s recovery plan would have the larger effect on equilibrium expenditure, other things remaining the same? The spending on transportation projects will have the larger effect because the expenditure multiplier is larger than the tax multiplier The expenditure multiplier is larger because in the first round all of the increased government expenditure increases aggregate expenditure whereas part of a tax cut is saved and hence does not increase aggregate expenditure Use the following news item to work Problems 25 to 27 The BEA reported that in the third quarter of 2014 U.S exports increased by $40 billion 25 Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium expenditure in the short run The increase in exports increases aggregate expenditure because exports is a component of aggregate expenditure As shown in Figure 11.3, the aggregate expenditure curve shifts upward from AE to AE1 Because aggregate expenditure has increased, real GDP increases, In Figure 11.3 the increase in aggregate expenditure increases real GDP from $15.8 trillion to $16.0 trillion Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the short run The increase in exports increases aggregate expenditure and creates an increase in the aggregate demanded Figure 11.4 illustrates the effect on real GDP The aggregate demand curve shifts rightward, from AD0 to AD1 The price level rises and equilibrium real GDP increases from $15.8 trillion to $15.9 trillion The economy is in an above full-employment equilibrium 147 148 CHAPTER 11 E X P E N D I T U R E M U LT I P L I E R S 27 Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the long run In the short run, the economy is in an above full-employment equilibrium As time passes, the money wage rate rises, which decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward Eventually the short-run aggregate supply decreases enough so that the economy returns to full employment In Figure 11.5, this analysis means that the short-run aggregate supply curve eventually shifts from SAS to SAS and the economy returns to full employment, with real GDP of $15.8 trillion and a price level of 122 28 Compare the multiplier in the short run and the long run and explain why they are not identical The long-run multiplier is zero, which means that the short-run multiplier is larger than the long-run multiplier The long-run multiplier equals zero because in the long run the economy returns to full employment For example, in the short run an increase in aggregate demand increases real GDP, which means that the short-run multiplier is positive But the economy is at a greater than full-employment equilibrium Therefore the money wage rate starts to rise The rise in the money wage rate decreases short-run aggregate supply and thereby decreases real GDP The short-run aggregate supply continues to decrease until the economy reaches full employment, at which point it stops decreasing But the ultimate change in real GDP is zero, which means the long-run multiplier is zero Use the following news clip to work Problems 29 to 31 Japan's Economy Grows Faster Than Expected Japanese economy has staged an encouraging comeback in the first quarter The growth in GDP has been driven by private consumption that had remained long an obstacle in the country’s economic recovery whereas capital expenditure has risen for the first time in four quarters Source: CNBC, May 19, 2015 29 Is capital expenditure part of induced expenditure or autonomous expenditure? Explain Induced consumption expenditure is the expenditure that varies with real GDP while autonomous expenditure does not vary with real GDP Under the Keynesian model, government spending is assumed to be constant and hence it does not vary with income Capital expenditure is, therefore, part of autonomous expenditure 149 150 30 CHAPTER 11 Examine how Japan’s real GDP increases due to a movement along the aggregate demand curve and a shift in the aggregate demand curve Illustrate your answer using a graph Keeping the price level fixed, an increase in private consumption and capital expenditure leads to a rightward shift in the aggregate demand curve Figure 11.6 illustrates these differences The change from point A to point B reflects a change in aggregate demand If the increase in consumption and capital expenditure results from lower prices, it creates a change in the quantity of real GDP demanded The movement from point B to point C reflects a change in the quantity of real GDP demanded 31 Explain using a graph how in the Keynesian model, keeping the price level fixed, an increase in private consumption influences aggregate expenditure and aggregate demand In the Keynesian model, keeping the price level unchanged, an increase in private consumption increases the aggregate expenditure and aggregate demand As illustrated in Figure 11.7a, the increase in private consumption shifts the aggregate expenditure curve upward, from AE to AE and in Figure 11.7b the aggregate demand curve shifts rightward, from AD0 to AD1 E X P E N D I T U R E M U LT I P L I E R S 32 Japan Slides Into Recession In Japan, consumer prices slid at a faster pace in July and industrial production unexpectedly slumped Source: Bloomberg, September 1, 2012 Contrast what the news clip says is happening in Japan with what is happening in the United States in Problem 29 and provide a graphical analysis of the differences The news clip suggests that in Japan aggregate demand is decreasing so that both the price level and real GDP are decreasing Figure 11.8a shows this situation The information in Problem 29 suggests that consumption expenditure is increasing and, while investment (capital spending) is decreasing However it seems that the change in consumption expenditure exceeds the change in investment so U.S aggregate demand is increasing Figure 11.8b shows this situation 151 152 CHAPTER 11 Economics in the News 33 After you have studied Economics in the News on pp 322–323 (730–731 in Economics), answer the following questions a If the 2014 changes in inventories were mainly planned changes, what role did they play in shifting the AE curve and changing equilibrium expenditure? Use a two-part figure (similar to that on p 310 (p 718 in Economics)) to answer this question Figure 11.9a shows aggregate planned expenditure; Figure 11.9b shows unplanned inventory change When aggregate planned expenditure is given by AE 0, unplanned inventory change is equal to zero when real GDP is $16.0 trillion, so unplanned inventory change is given by the top line in Figure 11.9b If the change in inventories was planned, then planned investment increased and with it aggregate planned expenditure also increased The increase in aggregate planned expenditure shifts the aggregate expenditure curve upward, as illustrated by the shift from AE0 to AE1 in Figure 11.9a It shifts the unplanned inventory change line downward to the lower curve, Unplanned inventory change 1, in Figure 11.9b The increase in aggregate expenditure increases equilibrium real GDP In figure 11.9a, real GDP increases from $16.0 trillion to $16.1 trillion In Figure 11.9b, at real GDP of $16.1 trillion, along the new unplanned inventory change curve line, unplanned inventory change is zero b The BEA news release reports that exports of goods and services were up 10.1 percent and imports of goods and services were up 11.0 percent Were these increases in expenditure increases in autonomous expenditure or increases in induced expenditure, and how they influence the magnitude of the multiplier? Changes in exports are autonomous expenditure and changes in imports are induced expenditure Changes in exports have no effect on the magnitude of the multiplier Changes in imports affect the size of the multiplier The larger the quantity of imports that are induced by a change in income, the smaller the multiplier E X P E N D I T U R E M U LT I P L I E R S c Using the assumptions made in Figure on p 323 (p 731 in Economics), what is the value of the autonomous expenditure multiplier? The autonomous expenditure multiplier equals 1/(1 – slope of AE line) In the figure, the slope along the top red line is equal to ($15.99 trillion − $15.91 trillion)/ ($15.99 trillion − $15.83 trillion) = ($0.08 trillion)/(($0.16 trillion) = 0.5 So the autonomous expenditure multiplier equals 1/(1 – 0.5) = 2.0 34 In an economy with a fixed price level, autonomous spending is $20 trillion and the slope of the AE curve is 0.6 a What is the equation of the AE curve? The equation of the AE curve is AE = 20 + 0.6Y, where Y is real GDP and the 20 is $20 trillion b Calculate equilibrium expenditure Equilibrium expenditure is $50 trillion Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP That is, AE = 20 + 0.6Y and AE = Y Solving these two equations for Y gives equilibrium expenditure of $50 trillion c Calculate the multiplier The multiplier equals 1/(1 the slope of the AE curve) The equation of the AE curve tells us that the slope of the AE curve is 0.6 So the multiplier is 1/(1 0.6), which is 2.5 d Calculate the shift of the aggregate demand curve if investment increases by $1 billion The shift of the aggregate demand curve equals the multiplier multiplied by the change in investment, or 2.5 × $1 billion, which is $2.5 billion 153 ... equilibrium levels, an unplanned decrease in inventories occurs The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels The increase in production... equilibrium levels, an unplanned increase in inventories occurs The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels The decrease in production... American, December 11, 2 011 and the Bureau of Economic Analysis 143 144 CHAPTER 11 17 Explain and draw a graph to illustrate how a fall in household wealth would be expected to influence the consumption
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