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Chapter 10
1. Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate.
Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock. As Figure 10.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS0 to SAS1 and from LAS0 to LAS1.
Fuel prices rise.
The rise in fuel prices raises firms’ costs. Short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Long-run aggregate supply does not change. Figure 10.2 shows the leftward shift of the short-run aggregate supply curve from SAS0 to SAS1.
When Starbucks and Wal-mart open in India, short-run and long-run aggregate supply increase. When these stores open, employment at full employment increases and India’s capital stock increases. Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 10.1.
Increasing the number of engineering graduates increases India’s human capital. Both the short-run and long-run aggregate supply increases, as shown in Figure 10.1 by the rightward shifts in the short-run and long-run aggregate supply curves.
An increase in the money wage rate increases firms’ costs. Short-run aggregate supply decreases but long-run aggregate supply does not change. Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run employment does not change. This situation is illustrated in Figure 10.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change.
The price level in India increases.
In the short run, an increase in the price level increases the quantity of real GDP demanded. In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied. These results are illustrated in Figure 10.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS.
2. Wages Could Hit Steepest Plunge in 18 Years
A bad economy is starting to drag down wages for millions of workers. The average weekly wage has fallen 1.4% this year through September. Colorado will become the first state to lower its minimum wage since the federal minimum wage law was passed in 1938, when the state cuts its rate by 4 cents an hour.
Source: USA Today, October 16, 2009
Explain how the fall in the average weekly wage and the minimum wage will influence aggregate supply.
A fall in the average weekly wage rate increases short-run aggregate supply. However it has no effect on long-run aggregate supply because in the long run the price level will fall by the same percentage and therefore firms have no incentive to change their production. The fall in the minimum wage increases both short-run and long-run aggregate supply. The fall in the minimum wage increases employment at full employment, thereby boosting potential GDP which increases both the short-run and long-run aggregate supply. The effect from the 4¢ per hour fall in Colorado’s minimum wage, however, is likely to be miniscule.
3. Chinese Premier Wen Jiabao has warned Japan that its companies operating in China should raise pay for their workers. Explain how a rise in wages in China will influence the quantity of real GDP supplied and aggregate supply in China.
A rise in the wage paid in China decreases short-run aggregate supply because it boosts firms’ costs. In the long run, however, it will have no effect because the price level will rise by the same percentage, thereby offsetting firms’ short-run incentive to cut production.
4. Canada trades with the United States. Explain the effect of each of the following events on Canada’s aggregate demand.
Cutting income taxes increases aggregate demand because it increases people’s disposable incomes.
Strong growth in the United States increases U.S. demand for Canadian exports. Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases.
To upgrade their facilities, power utilities must increase their investment. Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases.
5. The Fed cuts the quantity of money and all other things remain the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run.
A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward. By cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other big-ticket items. The decrease in consumption expenditure and investment both decrease aggregate demand.
6. Mexico trades with the United States. Explain the effect of each of the following events on the quantity of real GDP demanded and aggregate demand in Mexico.
If the United States goes into a recession, the demand for Mexican exports decreases. Exports are a component of aggregate demand, so the decrease in exports decreases Mexico’s aggregate demand.
The rise in the Mexican price level decreases the quantity of real GDP demanded in Mexico. There is no change in Mexico’s aggregate demand.
An increase in the quantity of money lowers the interest rate and increases consumption expenditure and investment. Mexico’s aggregate demand increases.
7. Durable Goods Orders Surge in May, New-Homes Sales Dip
The Commerce Department announced that demand for durable goods rose 1.8 percent, while new-home sales dropped 0.6 percent in May. U.S. companies suffered a sharp drop in exports as other countries struggle with recession.
Source: USA Today, June 24, 2009
Explain how the items in the news clip influence U.S. aggregate demand.
The increase in durable goods increased U.S. aggregate demand. However the fall in new home sales and in exports decreased U.S. aggregate demand.
Use Figure 10.4 to work Problems 8 to 10.
Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0.
8. Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed? If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium?
Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S. exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105. The economy is at an above full-employment equilibrium with an inflationary gap.
9. Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap?
Aggregate supply decreases when the aggregate supply curve shifts from AS0 to AS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105. The economy is at a below full-employment equilibrium with a recessionary gap.
10. Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1. What is the new macroeconomic equilibrium?
After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110. The economy is at a full-employment equilibrium.
Use the following data to work Problems 11 to 13.
The following events have occurred in the history of the United States:
11. Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them.
A deep recession in the world economy decreases aggregate demand. A sharp rise in oil prices decreases short-run aggregate supply. The expectation of lower future profits decreases investment and decreases aggregate demand.
12. Explain the separate effects of each event on U.S. real GDP and the price level, starting from a
position of long-run equilibrium.
A deep recession in the world economy decreases aggregate demand, which decreases real GDP and lowers the price level. A sharp rise in oil prices decreases short-run aggregate supply, which decreases real GDP and raises the price level. The expectation of lower future profits decreases investment and decreases aggregate demand, which decreases real GDP and lowers the price level.
13. Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium.
The combined effect of a deep recession in the world economy, a sharp rise in oil prices, and the expectation of lower future profits decreases both aggregate demand and short-run aggregate supply, which decreases real GDP and the price level rises, falls, or remains the same.
Use the following data to work Problems 14 and 15.
|
|
Real GDP demanded |
Real GDP supplied in the short run |
|
(billions of 2005 dollars) |
||
|
100 |
1,150 |
1,050 |
|
110 |
1,100 |
1,100 |
|
120 |
1,050 |
1,150 |
|
130 |
1,000 |
1,200 |
|
140 |
950 |
1,250 |
|
150 |
900 |
1,300 |
|
160 |
850 |
1,350 |
The table shows the aggregate demand and short-run aggregate supply schedules of a country in which potential GDP is $1,050 billion.
14. What is the short-run equilibrium real GDP and price level?
The short-run equilibrium real GDP and price level are determined by the price level that sets the quantity of real GDP demanded equal to the quantity of real GDP supplied in the short run. From the table, the short-run equilibrium real GDP is $1,100 billion and the price level is 110.
15. Does the country have an inflationary gap or a recessionary gap and what is its magnitude?
Equilibrium real GDP exceeds potential GDP, so the country has an inflationary gap. The inflationary gap equals the difference between real GDP and potential GDP, which is $50 billion.
16. Geithner Urges Action on Economy
Treasury Secretary Timothy Geithner is reported as having said that the United States can no longer rely on consumer spending to be the growth engine of recovery from recession. Washington needs to plant the seeds for business investment and exports. “We can’t go back to a situation where we’re depending on a near short-term boost in consumption to carry us forward,” he said.
Source: The Wall Street Journal, September 12, 2010
a. Explain the effects of an increase in consumer spending on the short-run macroeconomic equilibrium.
Consumption expenditure is part of aggregate demand, so an increase in consumer expenditure increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.
b. Explain the effects of an increase in business investment on the short-run macroeconomic equilibrium.
Investment is part of aggregate demand, so an increase in investment increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.
c. Explain the effects of an increase in exports on the short-run macroeconomic equilibrium.
Exports are part of aggregate demand, so an increase in exports increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.
17. Describe what a classical macroeconomist, a Keynesian, and a monetarist would want to do in response to each of the events listed in Problem 11.
Classical and monetarist economists probably would recommend no policy action for all three of the events. If they suggested any policy at all, the policy would involve cutting taxes. A Keynesian economist likely would suggest several policies for all three events, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. The Keynesian economist also would suggest that the Fed should increase the quantity of money and lower interest rates.
18. Adding Up the Cost of Obama’s Agenda
When campaigning, Barack Obama has made a long list of promises for new federal programs costing tens of billions of dollars. Obama has said he would strengthen the nation’s bridges and dams ($6 billion a year), extend health insurance to more people (part of a $65-billion-a-year health plan), develop cleaner energy sources ($15 billion a year), curb home foreclosures ($10 billion in one-time spending) and add $18 billion a year to education spending. In total a $50-billion plan to stimulate the economy through increased government spending. A different blueprint offered by McCain proposes relatively little new spending and tax cuts as a more effective means of solving problems.
Source: Los Angeles Times, July 8, 2008
a. Based upon this news clip, explain what macroeconomic school of thought Barack Obama most likely follows.
Mr. Obama most likely follows the Keynesian (or new Keynesian) approach because he is making proposals that increase aggregate demand to offset the recessionary economy.
b. Based upon this news clip, explain what macroeconomic school of thought John McCain most likely follows.
Mr. McCain most likely follows the classical (or new classical) approach because he believes that the private sector, aided by tax cuts, should handle the recessionary economy.
19. Based on the news clip in Problem 16, explain what macroeconomic school of thought Treasury Secretary Timothy Geithner most likely follows?
The clip does not make totally clear Mr. Geithner’s views. He stated that “Washington needed to plant the seeds for business investment and exports.” If “planting the seeds” means cutting taxes to minimize their disincentive effects, then Mr. Geithner might follow the classical school. Much more likely, however, Mr. Geithner is recommending an active fiscal policy of tax cutting in order to combat the recession. In this case Mr. Geithner is following the Keynesian school.
Chapter 11
Use the following data to work Problems 1 and 2.
|
Disposable income |
Consumption expenditure |
|
(billions of pounds per year) |
|
|
300 |
340 |
|
400 |
420 |
|
500 |
500 |
|
600 |
580 |
|
700 |
660 |
You are given the information in the table about the economy of the United Kingdom.
1. Calculate the marginal propensity to consume.
The marginal propensity to consume is the fraction of a change in disposable income that is consumed. In the United Kingdom, when disposable 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.
|
Disposable income |
|
|
(billions of pounds per year) |
|
|
300 |
40 |
|
400 |
20 |
|
500 |
0 |
|
600 |
20 |
|
700 |
40 |
2. Calculate saving at each level of disposable income and calculate the marginal propensity to save.
The table to the right shows the United Kingdom’s saving schedule. Saving equals disposable income minus consumption expenditure.
The marginal propensity to save is the fraction of a change in disposable income that is saved. In the United Kingdom, for each increase in disposable income of £100 billion, saving increases by £20 billion, so the marginal propensity to save is £20 billion ÷ £100 billion, which is 0.2.
3. The U.S. and China’s Savings Problems
Last year China saved about half of its gross domestic product while the United States saved only 13 percent of its national income. The contrast is even starker at the household level—a personal saving rate in China of about 30 percent of household income, compared with a U.S. rate that dipped into negative territory last year (–0.4% of after-tax household income). Similar extremes show up in the consumption shares of the two economies.
Source: Fortune, March 8, 2006
Compare the MPC and MPS in the United States and China. Why might they differ?
The MPC is (much) higher in the United States than in China. Correspondingly the MPS is (much) lower in the United States than in China. The MPC might be higher in the United States because the return to saving (and the cost of borrowing) is lower in the United States than in China. Additionally U.S. residents might be more confident about their futures and so willing to save less out of additional income than Chinese residents who might be less confident about their futures and so save more out of additional income.
Use Figure 11.1 to work Problems 4 and 5.
Figure 11.1 illustrates the components of aggregate planned expenditure on Turtle Island. Turtle Island has no imports or exports, the people of Turtle Island pay no incomes taxes, and the price level is fixed.
4. 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.
5. 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.
6. 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.
7. Recovery?
In the second quarter, businesses increased spending on equipment and software by 21.9%, while a category that includes home building grew amid a rush by consumers to take advantage of tax credits for homes.
Source: The Wall Street Journal, July 31, 2010
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 8 and 9.
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.
8. 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.
9. 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.
Use the following data to work Problems 10 and 11.
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.
10. Calculate the multiplier and the marginal propensity to consume.
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 there are no imports and no taxes, the multiplier can be calculated from the formula that the multiplier equals 1/(1 - MPC). The multiplier equals 4.0, so 4.0 = 1/(1 - MPC). Solving this formula for the MPC shows that the MPC equals 0.75.
11. What happens to the multiplier if an income tax is introduced?
If an income tax is introduced, the multiplier decreases in value.
Use the following data to work Problems 12 to 16.
Suppose that the economy is at full employment, the price level is 100, and the multiplier is 2. Investment increases by $100 billion.
12. 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 2 and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion.
13. 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 2 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.
14. 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.
15. 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.
16. 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 2 because the short-run increase in real GDP is less than $200 billion. The long-run multiplier is even smaller. It equals zero.
Use the following news clip to work Problems 17 and 18.
Understimulated
A stimulus package would send more than $100 billion to American taxpayers before the end of 2008. The theory behind the rebates is that American taxpayers will take the cash and spend it—thus providing a jolt of stimulus to the economy. But will they? In 2001, Washington sought to jolt the economy back into life with tax rebates. In all, 90 million households received some $38 billion in cash. Months later, economists discovered that households spent 20 to 40 percent of their rebates during the first three months and about another third during the following three months. People with low incomes spent more.
Source: Newsweek, February 7, 2008
17. Will $100 billion of tax rebates to American consumers increase aggregate expenditure by more than, less than, or exactly $100 billion? Explain.
The $100 billion of tax rebates increase aggregate expenditure by more than $100 billion because the spending from the $100 billion increase in disposable income has a multiplied effect on the aggregate expenditure. Part of the $100 billion increase in disposable income is spent, leading the recipients’ incomes to increase. In turn, part of this increase in income is spent, thereby further increasing aggregate expenditure.
18. Explain and draw a graph to illustrate how this fiscal stimulus will influence aggregate expenditure and aggregate demand in both the short run and the long run.
Presuming the economy starts at its long-run equilibrium, Figure 11.2 shows the short-run and long-run effects on aggregate expenditure (Figure 11.2a) and on aggregate demand (Figure 11.2b). In the short run the rebate checks increase aggregate expenditure and aggregate demand. The aggregate expenditure curve shifts upward from AE0 to AE1 and the aggregate demand curve shifts rightward from AD0 to AD1. (The initial upward shift in the aggregate expenditure curve is larger but the increase in the price level moderated the initial increase in aggregate expenditure.) In the long run, however, short-run aggregate supply decreases and the short-run aggregate supply curve shifts from SAS0 to SAS1. While the higher price level does not shift the aggregate demand curve, it does shift the aggregate expenditure downward from AE1 back to AE0.
Use the following news clip to work Problems 19 to 21.
Working Poor More Pinched as Rich Cut Back
Cutbacks by the wealthy have a ripple effect across all consumer spending, said Michael P. Niemira, chief economist at the International Council of Shopping Centers. The top 20 percent of households spend about $94,000 annually, almost five times what the bottom 20 percent spent and more than what the bottom sixty percent combined spend. Then there’s also the multiplier effect: When shoppers splurge on $1,000 dinners and $300 limousine rides, that means fatter tips for the waiter and the driver. Sales clerks at upscale stores, who typically earn sales commissions, also depend on spending sprees of mink coats and jewelry. But the trickling down is starting to dry up, threatening to hurt a broad base of low-paid workers.
Source: MSNBC, January 28, 2008
19. Explain and draw a graph to illustrate the process by which “cutbacks by the wealthy have a ripple effect.”
If the wealthy cut back on their consumption expenditure, then aggregate planned expenditure decreases. The decrease in aggregate expenditure means that aggregate demand decreases. Figure 11.3a shows the decrease in aggregate expenditure as the downward shift in the aggregate planned expenditure curve from
AE0 to AE1. Figure 11.3b shows the decrease in aggregate demand as the shift in the aggregate demand curve from AD0 to AD1. Figure 11.3b shows that the price level falls, from 126 to 122 in the figure. The fall in the price level increases aggregate expenditure so that the aggregate expenditure curve shifts upward from AE1 to AE2. Real GDP decreases, from $13.0 trillion to $12.6 trillion in the figures.
20. Explain and draw a graph to illustrate how real GDP will be driven back to potential GDP in the long run.
In the short run real GDP decreases so it is less than potential GDP, and the unemployment rate exceeds the natural unemployment rate. This higher-than-normal unemployment rate leads to a fall in the money wage rate. The fall in the money wage rate increases short-run aggregate supply, which raises real GDP and further lowers the price level. As the price level falls, aggregate expenditure increases. Eventually real GDP returns to potential GDP, at which time the price level stops falling. Figure 11.4a and 11.4b (above) show these changes. In Figure 11.4b the short-run aggregate supply curve shifts rightward from SAS0 to SAS1. In the long run the price level falls to 118. In Figure 11.4a the lower price level increases aggregate expenditure so that the aggregate expenditure curve shifts upward from AE2 back to AE0.
21. Why is the multiplier only a short-run influence on real GDP?
The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes. The change in the money wage rate affects short-run aggregate supply and lowers the price level. The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium. The long-run change in aggregate expenditure offsets the initial multiplier effect on real GDP.
22. In the Canadian 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.
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.