Solution Manual for Macroeconomics, 16th Canadian

Edition, Christopher T.S. Ragan

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Solution Manual for Macroeconomics, 16th Canadian Edition, Christopher T.S. Ragan

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Part Eight

The Economy in the Short Run

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This pPart of the book contains three core theory chapters for analyzing the real macro economy in
the short run. It is here that we build the basic short-run model of national-income determination that
forms the foundation for most of what follows in the remainder of the book. In these three chapters,
we develop only the real side of the economy, leaving the monetary aspects to be developed after
our detailed treatment of the long run in Part 9.

There are two logical halves to this pPart of the book. In the first, Chapters 21 and 22 develop
the distinction between desired and actual aggregate expenditure and then put these concepts together
in the Keynesian Cross apparatus to illustrate the meaning of equilibrium. We explain the multiplier
in considerable detail. Note that these first two chapters are built around two related assumptions:
• the price level is constant; and
• the level of output is demand determined.
In the second logical half of the Part, Chapter 23 relaxes these two assumptions. We introduce
the aggregate demand (AD) and aggregate supply (AS) curves and show how these tools can be used
to examine the simultaneous determination of real GDP and the price level. AD and AS curves are
considered the most effective tools for studying macroeconomic behaviour, at least at the
introductory level. But these concepts are not simple to teach. Significant classroom time spent at
this point will have its payoff later when macroeconomic topics and policies can be understood better
as a result.

***

In Chapter 21, we present the Keynesian Cross of the AE curve and the 45-degree line in a simple
model of a closed economy without government. This simple structure allows us to determine
equilibrium income when the price level is constant, output is demand determined, and all of the
parts of the model are easy to see. In Chapter 22, we add government and foreign trade, still keeping
the assumptions that the price level is constant and real GDP is demand determined.

There are significant benefits to breaking the discussion of the Keynesian Cross into two
chapters. First, the version of the model in Chapter 21 with a closed economy and no government
allows the students to learn and become comfortable with three difficult but crucial concepts in the
simplest possible setting—desired versus actual expenditure, equilibrium national income, and the
simple multiplier. Second, Chapter 22 not only introduces the student to government and
international trade, but it also forces them to think through the equilibrium and multiplier concepts

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 Chapter 21: The Simplest Short-Run Macro Model 227

a second time. Our experience suggests that students need to see and work with this material several
times before they really know it, and therefore in our view this two-chapter approach is desirable.

Chapter 23 introduces the concept of the AD curve as the locus of price-income combinations
that yield expenditure equilibrium (purchasers are just prepared to purchase the total GDP that is
produced). After that, we introduce the AS curve and determine macroeconomic equilibrium as the
combination of real GDP and the price level at which (1) purchasers are willing to buy the total GDP
that is produced, and (2) producers are willing to supply that same level of GDP. In past editions
there has been somewhat of a bias toward the demand side of the economy. We have redressed this
by stressing the importance of supply shocks, both positive and negative.

***

Our view is that there are significant benefits from delaying the AD/AS analysis until after the
constant-price, Keynesian Cross model is fully developed. We realize that some other textbooks, in
an early attempt to interest the students by showing them what the completed model will be able to
do, put an introductory chapter with AD/AS analysis before the chapters with the Keynesian Cross.
In our view, however, this approach is difficult to defend on pedagogic grounds. We stress that the
AD curve is an equilibrium locus (which embodies the simple multiplier) rather than an ordinary
demand curve. Students can only fully appreciate this point, however, after they have understood the
equilibrium and the simple multiplier developed in the Keynesian Cross model.

Two Caveats on Terminology: We use terminology whereby a change in demand means a shift
in the AD curve while a change in quantity demanded refers to a movement along the AD curve (and
similarly for the AS curve). Shifts in the AD and AS curves are called demand shocks and supply
shocks, respectively. Readers have indicated that there is a wide divergence in the use of the word
“shock”. Some use it to mean unexpected shifts and others to mean any shift. We have chosen the
latter terminology. No matter of substance turns on this use of words. As long as instructors
understand that we use the word “shock” as a synonym for a shift, whether anticipated or
unanticipated, all should be well.

Another caveat concerns our labelling of the aggregate supply curve as AS rather than SRAS. Our
view is that the “SR” makes learning a little more cumbersome for students and adds no real benefit.
By using just AS to label the aggregate supply curve, our treatment is symmetric with the demand
side. We continue to assume (and emphasize throughout) that factor prices and technology are
constant when we draw any given AS curve, and that changes in factor prices or technology cause
the AS curve to shift. In later chapters, we replace the label LRAS with Y*, and simply refer to Y* as
the “anchor” to which real GDP returns after all adjustment has occurred.

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 _____________________________________________

Chapter 21: The Simplest Short-Run Macro Model

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In both this chapter and the next, we hold the price level constant and exogenous (as well as the
interest rate and the exchange rate). We thus develop the well-known Keynesian Cross apparatus.
This model should not be taken literally, as it once was, as a description of all of the forces that help
to determine national income in the short run. Instead, it merely determines the level of income at
which agents will willingly purchase exactly what is produced, given the existing price level and
levels of investment and government expenditures. The analysis of these forces is only the first step
toward the derivation of the AD curve, which allows for the influence on demand of changes in the
price level. The AD curve, in turn, is just one step toward the simultaneous determination of real
GDP and the price level by the combined forces of aggregate demand and aggregate supply.

***

This chapter is divided into three sections. In the first section, we develop the important distinction
between desired and actual expenditure. We then go on to discuss the determinants of desired
consumption and investment. Our streamlined discussion of consumption and saving leads to a box
containing an intuitive discussion of the differences between the Keynesian consumption function,
in which current consumption depends only on current income, and the Friedman-Modigliani
consumption functions, in which current consumption depends on some concept of “permanent” or
“lifetime” income. In the spirit of the permanent-income theory, wealth is also introduced as a
variable even in the simple consumption function. The discussion of wealth is in preparation for
shifts in the consumption function brought about when changes in the price level cause changes in
private-sector wealth. We have tried to be especially clear and systematic in our treatment of what
causes the consumption function to shift, including changes in interest rates, wealth, and
expectations.

Our discussion of investment examines the importance of the real interest rate, changes in sales,
and business confidence. We present some data on investment so students can see for themselves
the volatility of its various components. After this discussion, however, we then make it clear that
the remainder of the chapter treats investment as autonomous expenditure (with respect to national
income). The section closes by summing desired consumption and desired investment together to
get the desired aggregate expenditure (AE) function. Note that we reserve the term marginal
propensity to spend to apply to the relationship between total expenditure and national income.
The chapter’s second section introduces the concept of equilibrium national income—the level
of real GDP such that desired aggregate expenditure equals actual national income. We emphasize
the unintended changes in firms’ inventories as a way for the reader to understand what is happening
out of equilibrium.

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 Chapter 21: The Simplest Short-Run Macro Model 229

The final section of the chapter goes on to examine the effects of changes in autonomous
expenditure on equilibrium national income. We show that an increase in desired consumption is
equivalent to a reduction in desired saving. We then introduce the simple multiplier. Students usually
find the multiplier difficult at first sight, so we have taken care to introduce it slowly and to consider
it from more than one point of view. For those students who are not frightened by simple algebra, a
box provides a clear example of the power of formal reasoning, by deriving the multiplier relation
much more economically than can be done using words and geometry. Others can ignore the
algebraic box and focus instead on the intuition and the diagrams provided in the text. We also have
a discussion about realistic values for the multiplier in Canada. The chapter ends with a brief
discussion of the importance of expectations and the possibility of self-fulfilling prophesies in the
simple macro model.

Answers to Study Exercises

Fill-in-the-Blank Questions

Question 1
a) Ca + Ia (Note: we would also include Ga and NXa in an open economy with government)
b) C + I (Note: we would also include G and NX in an open economy with government)
c) actual; desired
d) autonomous; induced; a; b
e) autonomous
f) C + I; desired aggregate expenditure; actual national income (GDP)
g) $47 billion; 0.92; YD = Y (no taxes) and consumption is the only induced part of desired
expenditure

Question 2
a) accumulate; reduce; fall
b) fall; increase; rise
c) upward; rise; 45-degree
d) more; simple multiplier (× $10 billion)
e) larger; 1/(1-z)

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230 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Review Questions

Question 3

a) The consumption function shifts up and the AE function therefore shifts up. Equilibrium national
income increases. (Since the consumption function shift up, the saving function must shift down by
the same amount.)

b) The purchase of new houses is the residential component of investment. The investment function
shifts down, assuming that housing construction falls when house sales fall. This shifts the AE
function down and reduces the equilibrium level of national income.

c) This is a reduction in desired inventory investment caused by pessimism regarding the future state
of the economy. The investment function shifts down, the AE function shifts down, and equilibrium
national income falls.

d) The allowance of “accelerated depreciation” means that firms can claim larger costs for capital
depreciation than normal, thus improving the profitability of any given investment. The investment
function shifts up, the AE function shifts up, and equilibrium national income increases.

e) The rise in values in the stock market creates wealth (on paper) for those who own equities. This
increase in wealth leads to a rise in desired consumption, an upward shift in the consumption
function. The AE function shifts up and equilibrium national income rises. (Since the consumption
function shifts up, the saving function shifts down by the same amount.)

Question 4

a) National income accounting is based on actual expenditures. Desired expenditures are not
observed whereas actual expenditures are. It would be impossible to base accounting on an
unobserved concept.

b) A sudden decrease in desired consumer expenditure would result in a sudden decrease in actual
consumption. This would probably lead to an unanticipated increase in inventories, as consumers
are no longer buying as many goods as before, and so the unsold products accumulate in firms’
inventories. Inventories are part of investment, and so measured (actual) investment would rise. This
would be an increase in inventory investment.

c) See the figure below. Suppose the economy begins at point A, in equilibrium with national
output and income equal to YE. The sudden reduction in desired consumption is a downward shift
in the consumption function and thus in the AE function. The immediate effect is for desired
expenditure to fall to point B, even though production remains at YE. The vertical distance between
points A and B reflects the amount by which inventories are accumulating as a result of the
reduction in desired (and actual) consumer expenditure. This accumulation of inventories is an
unintended or unplanned increase in investment. The reduction in desired consumption

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 Chapter 21: The Simplest Short-Run Macro Model 231

expenditure will eventually, through the multiplier process, lead to a reduction in equilibrium
national income, and the economy will adjust toward point C.

Question 5

a) When actual national income is Y1, desired aggregate expenditure is b. Actual output is a and
so desired aggregate expenditure exceeds actual output. Inventories are being depleted — this is
unplanned negative inventory investment.

b) The depletion of inventories eventually leads firms to increase the level of output so they can
replenish their inventories. The rise in output generates a rise in income and this induces an
increase in desired aggregate expenditure. We move up and to the right along the AE curve. But
as long as AE exceeds actual output, the depletion of inventories leads firms to increase output.
The economy eventually settles down where AE cuts the 45-degree line. At this point actual output
is exactly equal to the level of desired aggregate expenditure, and the level of inventories is
constant.

c) When actual national income is Y2, desired aggregate expenditure is d. Actual output is e and so
desired aggregate expenditure is less than actual output. Inventories are being accumulated—this
is unplanned positive inventory investment.

d) The unintended accumulation of inventories eventually leads firms to reduce the level of output.
The reduction in output reduces income and this induces a decrease in desired aggregate
expenditure. We move down and to the left along the AE curve. But as long as AE is less than
actual output, the accumulation of inventories leads firms to reduce output. The economy
eventually settles down where AE cuts the 45-degree line. At this point actual output is exactly
equal to the level of desired aggregate expenditure, and inventories are neither being depleted nor
accumulated.

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232 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Question 6
To best examine this question, note that the equilibrium condition, Y = C + I, can also be expressed
as Y – C = I which is the same as S = I. So equilibrium in our simple macro model can be seen as
the level of national income at which desired saving equals desired investment.

With this in mind, consider the figure below, which shows the equilibrium level of national
income in terms of desired saving and desired investment. The initial equilibrium is point A. The
rise in desired saving shifts the saving function upward to S but does not affect the investment
function. The accompanying reduction in desired consumption leads to an unintended accumulation
of inventories and thus leads firms to reduce the level of output. After the multiplier has worked
itself out, the level of equilibrium income has fallen but the equilibrium level of saving is unchanged.
Thus, the attempt to increase saving leads to a reduction in national income but no increase in overall
saving — the “paradox of thrift”.

Question 7

It is easy in the model to allow for the possibility that investment has an induced component as well
as an autonomous component. In this case, the slope of the AE curve, which is ordinarily just equal
to the marginal propensity to consume, becomes MPC + β, where β is the marginal propensity to
invest. The new AE curve is obviously steeper than the AE curve in the simplest model. This increase
in the marginal propensity to spend implies that the simple multiplier increases.

One intriguing possibility is that β is sufficiently large that the marginal propensity to spend,
MPC + β, exceeds one. In this case, if the level of autonomous expenditure is positive, the AE
function would never intersect the 45-degree line and there would be no equilibrium. This unusual
possibility should force us to think about the reasons why there might be an induced component to

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 Chapter 21: The Simplest Short-Run Macro Model 233

desired aggregate investment, and whether the induced component is likely to be large. Recall that
we should not confuse current income with expected future income when discussing the determinants
of desired investment. Since investment is an activity done today in order to generate a return in the
future, it is future income that is likely to be the important determinant of current investment, not
current income. For this reason, there is a solid reason to expect a small or zero induced component
in current desired investment.

Problems

Question 8

a) The average propensity to consume (APC) is equal to desired consumption divided by disposable
income. See the completed table below.

YD C APC MPC
0 150 --- ---
100 225 2.25 75/100 = 0.75
200 300 1.50 75/100 = 0.75
300 375 1.25 75/100 = 0.75
400 450 1.125 75/100 = 0.75
500 525 1.05 75/100 = 0.75
600 600 1.00 75/100 = 0.75
700 675 0.96 75/100 = 0.75
800 750 0.94 75/100 = 0.75

b) See the table above. The marginal propensity to consume (MPC) is equal to the change in desired
consumption divided by the change in disposable income that brought it about. The MPC is shown
as the change from one row in the table to the next.
c) The equation for this consumption function is C = 150 + (0.75)YD. The constant term is the level
of autonomous desired consumption; the slope is the MPC.
d) See the figure below. The 45-degree line shows where desired consumption equals disposable
income. This occurs only once along the consumption function, at the break-even level of income,
Y*, which equals $600. The APC equals one at Y*. The slope of the consumption function is the
MPC, which in this case is 0.75.

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234 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Question 9

a) Desired saving is equal to disposable income minus desired consumption. We can compute desired
saving (S) from the table in Question 8. The plotted desired saving function is shown below. The
slope of the function is the marginal propensity to save, S/YD, which equals one minus the marginal
propensity to consume. In this case the marginal propensity to save is equal to 0.25.

YD C S
0 150 –150
100 225 –125
200 300 –100
300 375 –75
400 450 –50
500 525 –25
600 600 0
700 675 25
800 750 50

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 Chapter 21: The Simplest Short-Run Macro Model 235

b) To show this to be true, begin by noting that disposable income must either be consumed or saved.
Thus

YD = C + S

Now divide both sides by YD to get

1 = C/YD + S/YD

This shows that the average propensity to consume plus the average propensity to save must equal
one.

c) The equation for the saving function is S = -150 + (0.25)YD. The constant term is the level of
autonomous desired saving and the slope is the marginal propensity to save.

Question 10

a) See the table below.

Y C = 500 + .9Y I AE = C + I
0 500 + (.9)0 = 500 100 600
2000 500 + (.9)2000 = 2300 100 2400
4000 500 + (.9)4000 = 4100 100 4200
6000 500 + (.9)6000 = 5900 100 6000
8000 500 + (.9)8000 = 7700 100 7800
10000 500 + (.9)10000 = 9500 100 9600

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236 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

b) Autonomous expenditure is the sum of autonomous consumption and autonomous investment,

which in this model is 600.

c) In the model in this chapter, there is no government and hence no taxation. The result is that
disposable income, YD, is the same as national income, Y.

d) Equilibrium national income is that level of national income where actual income, Y, equals
desired aggregate expenditure, AE. Thus, the equilibrium level of national income is 6000.

Question 11

a) The (desired) aggregate expenditure function shows the total desired expenditure at each level of
national income.

AE = C + I  AE = 1400 + 0.8Y + 400  AE = 1800 + 0.8Y

b) Equilibrium requires that Y = AE (this is the equation for the 45-degree line). The equilibrium
level of national income is therefore the value of Y that solves the following equation:

Y = 1800 + 0.8Y  Y(1 – 0.8) = 1800  Y = 1800/(0.2)  Y = 9000

c) When Y = 9000, consumption equals 1400 + (0.8  9000) = 8600. Saving therefore equals Y – C
which is 9000 – 8600 = 400. Investment equals 400.

(Note that equilibrium national income can also be determined as that level of real GDP where
desired saving equals desired investment; see the Additional Topic on the book’s MyEconLab for
more information.)

Question 12

The marginal propensity to spend on national income (z) is the slope of the AE function, which in
the simple model of this chapter is just equal to the MPC. The simple multiplier is equal to 1/(1-z).

a) z = 0.4 ➔ simple multiplier = 1/(1-0.4) = 1/0.6 = 1.67

b) z = 0.62 ➔ simple multiplier = 1/(1-0.62) = 1/0.38 = 2.63

c) z = 0.92 ➔ simple multiplier = 1/(1-0.92) = 1/0.08 = 12.5

d) z = 0.57 ➔ simple multiplier = 1/(1-0.57) = 1/0.43 = 2.33
e) z = 0.2 ➔ simple multiplier = 1/(1-0.2) = 1/0.8 = 1.25
f) z = 0.35 ➔ simple multiplier = 1(1-0.35) = 1/0.65 = 1.54

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 Chapter 21: The Simplest Short-Run Macro Model 237

g) The size of the simple multiplier depends on the slope of the AE function, not its vertical height,
which is why it does not depend on the level of autonomous expenditure. As z rises, the slope of the
AE function also rises, and this means that there is more induced spending in response to any increase
in Y, which makes the multiplier process result in a larger total change in Y.

Question 13
a) See the figure below. When wealth is 10000, the AE function is

AE = 500 + 0.75Y + (.05)(10000) + 150  AE = 1150 + 0.75Y

Using the equilibrium condition, Y = AE, the equilibrium level of national income is the level of Y
that solves the following equation:

Y = 1150 + 0.75Y  Y(1 – 0.75) = 1150  Y = 1150/.25  Y = 4600

b) The marginal propensity to spend (on national income) is the slope of the AE function – it shows
how much desired spending rises when national income increases by $1. (In this model, with no
government and no foreign trade, the marginal propensity to spend is simply the marginal propensity
to consume.) Here, the marginal propensity to spend (which we denote z) is equal to 0.75.

c) The value of the simple multiplier is 1/(1 – z). In this economy, z = 0.75 and so the value of the
simple multiplier is 1/(1 – 0.75) = 1/(0.25) = 4.
d) If desired investment increases from 150 to 250, this is an increase in autonomous expenditure of
100. Given the multiplier of 4, the change in equilibrium national income will be 400. This is shown
in the diagram above as the AE function shifts to AE and equilibrium national income rises to 5000.

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Solution Manual for Macroeconomics, 16th Canadian Edition, Christopher T.S. Ragan

238 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

e) Let’s suppose that I has already increased to 250 as in part (d). If wealth now increases from 10000
to 15000, the level of autonomous consumption increases by 5000(.05) = 250. Thus the new AE
function becomes
AE = 1500 + (.75)Y

As households increase their autonomous consumption by 250, the AE function shifts up by 250 and
the equilibrium level of national income increases by 250×4 = 1000. Equilibrium national income
rises to 6000.

*****

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