Basic Macroeconomic Relationships
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Questions and Answers

What does it indicate when saving is zero?

  • Savings are positive.
  • Consumption equals disposable income. (correct)
  • Consumption exceeds disposable income.
  • Disposable income is negative.

What is the meaning of dissaving $5 billion?

  • Disposable income decreased by $5 billion.
  • Consumption is $5 billion less than disposable income.
  • Savings increased by $5 billion.
  • Total consumption exceeds total income by $5 billion. (correct)

According to the consumption schedule, what is the slope represented as?

  • 1.25
  • 1.00
  • 0.75 (correct)
  • 0.50

What is the marginal propensity to consume when the slope of the saving schedule is 1.33?

<p>0.75 (C)</p> Signup and view all the answers

At which level of disposable income does the saving become $5 billion?

<p>$450 billion (C)</p> Signup and view all the answers

How do changes in income primarily affect consumption?

<p>Higher income typically increases consumption. (A)</p> Signup and view all the answers

How is saving related to disposable income when consumption is positive?

<p>It can be either a positive or negative amount (A)</p> Signup and view all the answers

Which of the following factors can influence consumption other than income?

<p>Interest rates (A), Consumer confidence (C), Government policies (D)</p> Signup and view all the answers

What happens when consumption equals disposable income?

<p>Saving must be zero (D)</p> Signup and view all the answers

If disposable income increases to $490 billion, what is likely the consumption behavior?

<p>Consumption will increase. (C)</p> Signup and view all the answers

What tends to occur with the average propensity to consume as disposable income rises?

<p>It decreases (D)</p> Signup and view all the answers

What relationships are examined between economic aggregates in the chapter?

<p>Income and consumption (B)</p> Signup and view all the answers

What happens at the point where consumption equals disposable income?

<p>No new savings are generated. (D)</p> Signup and view all the answers

What is represented by the saving schedule in a graph?

<p>The level of savings across various income levels. (A)</p> Signup and view all the answers

Which statement best describes the relationship between average and marginal propensities to save?

<p>APS increases as DI rises (A)</p> Signup and view all the answers

How do real interest rates affect investment?

<p>Higher interest rates usually decrease investment. (C)</p> Signup and view all the answers

In which scenario is the average propensity to consume (APC) at its highest?

<p>When DI is at zero (B)</p> Signup and view all the answers

What can yield multiplied changes in GDP according to the chapter's overview?

<p>Changes in spending (A)</p> Signup and view all the answers

What is indicated by a consumption schedule slope of 0.75?

<p>For every $1 increase in income, consumption increases by $0.75. (B)</p> Signup and view all the answers

Which of the following best describes 'aggregate' as used in macroeconomics?

<p>The total or combined value of economic factors. (C)</p> Signup and view all the answers

At $470 billion of income, what is the calculated average propensity to consume (APC)?

<p>0.96 (C)</p> Signup and view all the answers

What is one of the primary questions addressed regarding investment in the chapter?

<p>How do changes in real interest rates affect investment? (D)</p> Signup and view all the answers

Which of the following statements about the marginal propensity to save (MPS) is accurate?

<p>MPS rises as disposable income rises (B)</p> Signup and view all the answers

What happens to household behavior when real interest rates fall?

<p>Households borrow more, consume more, and save less. (B)</p> Signup and view all the answers

Which factor is NOT directly examined in the context of consumption?

<p>Social norms (B)</p> Signup and view all the answers

How do changes in taxation affect consumption and saving schedules?

<p>Increase in taxes shifts both schedules downward. (A)</p> Signup and view all the answers

What is a consequence of lower interest rates on consumption?

<p>It shifts the consumption schedule slightly upward. (B)</p> Signup and view all the answers

What keeps the consumption and saving schedules relatively stable?

<p>Strong influences from long-term saving considerations. (D)</p> Signup and view all the answers

Which effect does an increase in taxes have on saving behavior?

<p>It encourages individuals to save less. (C)</p> Signup and view all the answers

What is the effect of higher interest rates on the consumption schedule?

<p>It decreases the overall consumption level. (D)</p> Signup and view all the answers

How do lower interest rates affect saving incentives?

<p>They diminish the saving incentive due to lower interest payments. (A)</p> Signup and view all the answers

What can lead to self-cancellation of changes in consumption and saving schedules?

<p>Nonincome determinants working in opposite directions. (D)</p> Signup and view all the answers

What should a firm do if the interest rate exceeds the expected rate of return?

<p>Reject the investment as it is expected to be unprofitable (B)</p> Signup and view all the answers

What does the firm do with its investment projects?

<p>Array projects from the highest expected rate of return downward (B)</p> Signup and view all the answers

How should the firm handle internal financing when investing?

<p>Consider the interest income foregone as an opportunity cost (C)</p> Signup and view all the answers

At what point should a firm stop investing in new projects?

<p>When the expected rate of return is less than the real interest rate (B)</p> Signup and view all the answers

What is the significance of the interest rate in the investment decision?

<p>It must be considered against the expected rate of return (C)</p> Signup and view all the answers

What does the data provide in the example of the investment projects?

<p>A breakdown of projects yielding various expected rates of return (B)</p> Signup and view all the answers

What happens when the expected rate of return equals the real interest rate?

<p>The firm has undertaken all profitable investments (A)</p> Signup and view all the answers

Why is opportunity cost important when investing internally?

<p>Because it reflects alternative uses for the funds (B)</p> Signup and view all the answers

What happens when each household individually attempts to save more during a recession?

<p>Total saving ability of households as a group decreases. (C)</p> Signup and view all the answers

What financial action would a business owner take if the expected net revenue from an investment exceeds its cost?

<p>Invest in the capital goods. (B)</p> Signup and view all the answers

How is the expected rate of return calculated?

<p>By dividing the profit by the cost of the investment. (C)</p> Signup and view all the answers

What does a nominal interest rate of 15 percent indicate in the presence of a 10 percent real rate of return?

<p>The investment is likely unprofitable. (D)</p> Signup and view all the answers

What effect does a collective reduction in total spending during a recession have on households?

<p>It drives down total income across the group. (A)</p> Signup and view all the answers

What is true about the conditions necessary for a business to decide to purchase capital goods?

<p>Only when they believe it will be profitable. (C)</p> Signup and view all the answers

If a sanding machine costs $1,000 and generates net expected revenue of $1,100, what is the profit after the cost is subtracted?

<p>$100 (C)</p> Signup and view all the answers

Why is it important to consider inflation when calculating the expected rate of return on an investment?

<p>Inflation adjusts the real value of returns on investments. (A)</p> Signup and view all the answers

Flashcards

Macroeconomic Relationships

Relationships between key economic factors like income, consumption, saving, interest rates, and investment, which affect the overall economy.

Income and Consumption

The relationship between a person's income and how much they spend (consume).

Income and Savings

The relationship between a person's income and how much they save.

Interest rate and Investment

The connection between borrowing costs (interest rates) and the decisions firms make to invest in capital goods.

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Spending and Output

Changes in spending can affect the total production (output) of goods and services in an economy.

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Aggregate

The total or combined amount of something, like income or spending, within an economy.

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Consumption

The amount of goods and services people buy.

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Investment

The purchase of new capital goods by companies for expansion, modernization, or new projects.

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Saving is zero

When consumption equals disposable income, saving is zero.

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Consumption schedule

A graph relating different levels of disposable income to levels of consumption.

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Saving schedule

Graph showing how saving changes with disposable income.

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Disposable income

Income available to spend or save after taxes and other deductions.

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Dissaving

Spending more than disposable income. This results in borrowing or using savings.

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Slope of consumption schedule (0.75)

This indicates that for every $1 increase in disposable income, consumption increases by $0.75.

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Saving $5 billion

When disposable income is greater than consumption.

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Dissaving $5 billion

When consumption is greater than disposable income.

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Marginal Propensity to Consume (MPC)

The proportion of extra income spent on consumption.

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Average Propensity to Consume (APC)

The proportion of total income that is spent on consumption.

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Average Propensity to Save (APS)

The proportion of total income that is saved.

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Constant MPC

The MPC stays the same regardless of income level.

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Inverse Relationship (Consumption & Income)

Consumption and income vary in opposite directions.

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Real Interest Rate

The interest rate adjusted for inflation. It reflects the true cost of borrowing or the real return on savings.

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Real Interest Rate and Consumption

When real interest rates decrease, people tend to consume more and save less because borrowing becomes cheaper and the return on savings diminishes.

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Real Interest Rate and Saving

Lower real interest rates discourage saving because the return on savings is reduced, leading to less incentive to save.

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Taxation and Consumption

An increase in taxes reduces disposable income, lowering both consumption and saving, as people have less money to spend and save.

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Taxation and Saving

Increased taxes lead to a decrease in saving as people have less disposable income to put aside.

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Stability of Consumption and Saving

The consumption and saving schedules tend to be relatively stable unless significantly affected by tax changes. These decisions are often influenced by long-term considerations like retirement or emergencies.

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Nonincome Determinants

Factors other than income that influence consumption and saving decisions, such as expectations, interest rates, and wealth.

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Self-Canceling Effects

When changes in nonincome determinants work in opposite directions, their net impact on consumption and saving might be minimal.

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Fallacy of Composition

The mistaken belief that what is true for an individual is also true for the whole group. This is often seen in economics when individual actions lead to unintended collective consequences.

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Expected Rate of Return

The anticipated profit from an investment, calculated as a percentage of the original investment cost.

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How do businesses decide to invest?

Businesses make investment decisions based on the expected rate of return. They will invest if the anticipated profit is high enough to justify the cost.

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Real Rate of Return

The rate of return on an investment adjusted for inflation, reflecting the actual purchasing power growth of your investment.

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Nominal Interest Rate

The stated interest rate on a loan or investment, without considering inflation.

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Relationship between real and nominal rates

The real rate of return is equal to the nominal interest rate minus the inflation rate.

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Profitable Investment (with inflation)

An investment is profitable when the expected real rate of return is higher than the real interest rate.

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Investment Decision with Inflation

Businesses must consider both the nominal interest rate and the inflation rate when making investment decisions to ensure a positive real rate of return.

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Investment Decision Rule

A firm should invest in projects only if the expected rate of return (r) exceeds the real interest rate (i).

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Opportunity Cost of Internal Funds

When a firm uses its own savings for investment, it forgoes the interest income it could have earned by lending those funds to someone else.

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Real Interest Rate vs. Nominal Rate

The real interest rate reflects the true cost of borrowing after accounting for inflation. The nominal rate is the stated interest rate.

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Arraying Investment Projects

Firms should rank potential investment projects from the highest expected rate of return (r) to the lowest and invest in those with r greater than the real interest rate (i).

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Investment to the Point Where r = i

A firm should invest until the point where the expected rate of return (r) equals the real interest rate (i).

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Investment Opportunity Curve

A graph that shows the total amount of investment available at different expected rates of return.

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Cumulative Investment for Each Rate of Return

The total investment amount that yields a specific rate of return or higher.

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Investment Decision in the Context of the Interest Rate

The interest rate plays a critical role in investment decisions. Firms should compare the expected rate of return to the real interest rate to determine the profitability of an investment.

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Study Notes

Basic Macroeconomic Relationships

  • Learning Objectives:
    • Describe how changes in income affect consumption and saving.
    • List and explain factors other than income that affect consumption.
    • Explain how changes in real interest rates affect investment.
    • Identify and explain factors other than the real interest rate that affect investment.
    • Illustrate how changes in investment (or other spending components) can increase or decrease real GDP by a multiple amount.

Income-Consumption and Income-Saving Relationships

  • Relationship: Income and consumption have a strong positive relationship. As income rises, consumption also rises, and vice-versa.
  • 45° Line: A reference line on a graph where consumption equals disposable income.
  • Saving: The difference between disposable income and consumption (DI - C).
  • Consumption Schedule: Shows the planned level of consumption at each level of disposable income.
  • Saving Schedule: Depicts the planned saving at each level of disposable income.
  • Average Propensity to Consume (APC): Ratio of consumption to disposable income.
  • Marginal Propensity to Consume (MPC): Ratio of a change in consumption to a change in disposable income.
  • Average Propensity to Save (APS): Ratio of saving to disposable income.
  • Marginal Propensity to Save (MPS): Ratio of a change in saving to a change in disposable income. Crucially, MPC + MPS = 1

The Interest-Rate-Investment Relationship

  • Investment: Expenditures on plants, equipment, machinery, inventories, etc.
  • Expected Rate of Return (r): Businesses invest if the expected rate of return is greater than the interest rate paid to borrow funds.
  • Real Interest Rate (i): Adjusted for inflation, this determines the cost of borrowing.
  • Investment Demand Curve: Plots the inverse relationship between the real interest rate and the quantity of investment demanded.

Shifts of the Investment Demand Curve

  • Non-Interest Factors:
    • Acquisition, Maintenance, and Operating Costs: Higher costs lower returns and shift the curve left. (Lower costs shift it right.)
    • Business Taxes: Higher taxes reduce profitability, shifting the curve left. Lower taxes shift it right.
    • Technological Change: Innovations increase returns, shifting the curve right.
    • Stock of Capital Goods: High-inventory levels suggest lower returns and shift the curve left; low inventory shifts it right.
    • Planned Inventory Changes: Increased planned inventories lead to increased investment, shifting the curve right.
    • Expectations: Optimistic expectations (e.g. of future sales) shift the curve right; pessimistic expectations shift the curve left.

Instability of Investment

  • Volatility: Investment spending is the most volatile component of total spending.
  • Factors Affecting Instability:
    • Expectations about future sales, profits, costs
    • Changes in technology
    • Irregular occurrences
    • Durability of capital goods
    • Changes in interest rates

The Multiplier Effect

  • Definition: An initial change in spending (e.g., investment) leads to a larger final change in real GDP.
  • MPC: The proportion of additional income that households spend. A higher MPC means a larger multiplier.
  • Multiplier: Ratio of the change in real GDP to the initial change in spending.
  • Rationale: Repetitive spending and income flow through the economy magnifies the initial impact.

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Description

This quiz covers fundamental concepts in macroeconomics, including the relationships between income, consumption, and saving. It also explores how real interest rates influence investment, as well as various factors affecting these economic variables. Understand these key principles to grasp how they impact real GDP.

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