Answers to Exercises

1. We study the consumption and saving functions together because one is just the mirror image of the other. Whatever income is not consumed must be saved; thus, the analysis of consumption is also the analysis of saving.

2. A flow is a variable that is measured over a period of time. A stock is a quantity that has accumulated over time. Stock: wealth, savings. Flow: income, saving, consumption, government expenditures, net exports, GDP.

3.

4. Consumption is stable over the business cycle because it is related to long-run permanent income rather than current income. When current income falls below permanent income, people dissave in order to maintain their permanent level of consumption. When the economy expands and current income rises above permanent income, people save more, again maintaining their permanent level of consumption. Investment spending, on the other hand, is much more volatile because it depends on business's expectations of profits, interest rates, the cost of capital, and other factors that change frequently.

5.

Assume that the initial position is I.

a. If the interest rate falls, the function shifts upward to I₁.
b. If an investment credit is repealed, the investment function shifts downward to I₂.
c. If a new president is a strong advocate of probusiness policies, profit expectations will improve, and the investment function will shift upward to I₁.
d. If there is a great deal of excess capacity in the economy, the investment function shifts downward to I₂.

6. a. MPC = .9
b. MPS = .1
c. MPI = .2
d.

e.

7. a. C = 50 + .9Y
b. I = 10
c. X = 160 - .2Y

d. AE = C + I + G + X
= 50 + .9Y + 10 + 20 + 160 - .2Y
= 240 + .7

8. No, the AE function shows the level of aggregate expenditures at alternative levels of real GDP. Aggregate demand is the macroeconomic "demand curve." And AD shows how aggregate expenditures change at alternative price levels.

9. a. $50
b. $1080
c. $130

10. a. .75
b. .5
c. .9

11. The fact that the intercept of the consumption function is not at C=0 allows the APC to fall even with a constant MPC. Since C is positive when real GDP equals zero, as consumption rises by a constant fraction of changes in real GDP, consumption will represent a smaller and smaller fraction of real GDP. If the intercept was located at the origin, then the APC would equal the MPC, the slope of the line, and the APC would not fall as income rises.

12. Older populations tend to have higher MPCs, since income tends to be lower for older households than middle-aged households, and people in retirement are frequently dissaving (living off the savings accumulated during their working years).

13.

a. U.S. net exports fall (as from X₁ to X₂).
b. U.S. net exports move out along a given net exports function (as along X₁).

c. U.S. net exports fall (as from X₁ to X₂).

d. U.S. net exports rise (as from X₁ to X₃).

14. Assuming autonomous I and G, the slope of the C + I + G line is determined by the MPC. The slope of the C + I + G + X function is determined by the MPC plus the MPI.

15. a. $200
b. 0.8
c. $1,000

Answers to Study Guide Homework

1. Disposable income, wealth, expectations, demographics, taxation

2. The interest rate, profit expectations, technological change, the cost of capital goods, capacity utilization

3. Foreign and domestic income, tastes, government trade restrictions, exchange rates

4. Government spending is determined by government policy; it is independent (autonomous) of disposable income.

5. a. Decreases investment and aggregate expenditures
b. Decreases investment and aggregate expenditures
c. Decreases consumption and aggregate expenditures
d. Decreases net exports and aggregate expenditures

Answers to Internet Exercise

This exercise explores the balance of trade and its relationship to the Aggregate Expenditures function. Students will access historical information regarding net exports and determine the impact of a net export deficit on aggregate expenditures.

3^rd Quarter 1980

2^nd Quarter 1987; $144.7 billion

2^nd Quarter 1975; $16.6 billion

Answers depend on date information is accessed.

A larger net exports deficit will cause a decrease in aggregate expenditures.