5/6/24, 4:23 AM Second Edition Textbook Chapter Problem Answers - 11

chapter:
11
Income and Expenditure
1. Due to an increase in consumer wealth, there is a $40 billion autonomous increase
in consumer spending in the economies of Westlandia and Eastlandia. Assuming that
the aggregate price level is constant, the interest rate is fixed in both countries, and
there are no taxes and no foreign trade, complete the accompanying tables to show
the various rounds of increased spending that will occur in both economies if the
marginal propensity to consume is 0.5 in Westlandia and 0.75 in Eastlandia. What do
your results indicate about the relationship between the size of the marginal propen-
sity to consume and the multiplier?

Westlandia

Incremental Total
change change
Rounds in GDP in GDP
1 DC = $40 billion ?
2 MPC × DC = ? ?
3 MPC × MPC × DC = ? ?
4 MPC × MPC × MPC × DC = ? ?
... ... ...
Total
change (1/(1 2 MPC)) 3 DC 5 ?
in GDP

Eastlandia
Incremental Total
change change
Rounds in GDP in GDP

1 DC = $40 billion ?
2 MPC × DC = ? ?
3 MPC × MPC × DC = ? ?
4 MPC × MPC × MPC × DC = ? ?
... ... ...
Total
change
in GDP (1/(1 2 MPC)) 3 DC 5 ?

11-1

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11-2 CHAPTER 11

Solution
1. The accompanying tables clearly show that the larger the marginal propensity to
consume, the larger the size of the multiplier. In Westlandia, with the marginal pro-
pensity to consume of 0.5, the multiplier equals 2. In Eastlandia, with the marginal
propensity to consume of 0.75, the multiplier equals 4.

Westlandia
Incremental Total
change change
Rounds in GDP in GDP

1 DC = $40 billion $40 billion

2 MPC × DC = $20 billion $60 billion
3 MPC × MPC × DC = $10 billion $70 billion
4 MPC × MPC × MPC × DC = $5 billion $75 billion
... ... ...
Total
change (1/(1 2 MPC)) 3 DC 5 (1/(1 2 0.5)) 3 $40 billion 5 $80 billion
in GDP

Eastlandia
Incremental Total
change change
Rounds in GDP in GDP

1 DC = $40 billion $40 billion

2 MPC × DC = $30 billion $70 billion
3 MPC × MPC × DC = $22.5 billion $92.5 billion
4 MPC × MPC × MPC × DC = $16.88 billion $109.38 billion
... ... ...
Total
change (1/(1 2 MPC)) 3 DC 5 (1/(1 2 0.75)) 3 $40 billion 5 $160 billion
in GDP

2. Assuming that the aggregate price level is constant, the interest rate is fixed, and there
are no taxes and no foreign trade, what will be the change in GDP if the following
events occur?
a. There is an autonomous increase in consumer spending of $2.5 billion; the
marginal propensity to consume is 2/3.
b. Firms reduce investment spending by $4 billion; the marginal propensity to con-
sume is 0.8.
c. The government increases its purchases of military equipment by $6 billion; the
marginal propensity to consume is 0.6.

Solution
2. a. The autonomous increase in consumer spending of $2.5 billion, with a marginal
propensity to consume of 2/3, will increase GDP by $7.5 billion, as follows:
Total change in GDP = (1/(1 − MPC)) 3 DC and putting in the values in the
question:
Total change in GDP = (1/(1 − 2/3)) 3 $2.5 billion = 3 3 $2.5 billion =
$7.5 billion.

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11-4 CHAPTER 11

b. To find the economy’s consumption function, we calculate aggregate consumer

spending at each level of aggregate disposable income:

ing is $14,500.

Aggregate autonomous consumer spending is $14,500, and the marginal

propensity to consume is 0.69 [= ($83,500 - $14,500)/($100,000 - $0)].
The aggregate consumption function is:
C = $14,500 + 0.69 × YD

4. From 2003 to 2008, Eastlandia experienced large fluctuations in both aggregate con-
sumer spending and disposable income, but wealth, the interest rate, and expected
future disposable income did not change. The accompanying table shows the level of
aggregate consumer spending and disposable income in millions of dollars for each of
these years. Use this information to answer the following questions.

Disposable income Consumer spending

Year (millions of dollars) (millions of dollars)

2003 $100 $180

2004 350 380
2005 300 340
2006 400 420
2007 375 400
2008 500 500

a. Plot the aggregate consumption function for Eastlandia.

b. What is the marginal propensity to consume? What is the marginal propensity to
save?
c. What is the aggregate consumption function?

Solution
4. a. The accompanying diagram shows the aggregate consumption function for
Eastlandia.

Consumer spending
(millions of dollars)
$600
CF
500

400

300

200

100

0 $100 200 300 400 500 600

Disposable income
(millions of dollars)

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INCOME AND EXPENDITURE 11-5

b. The marginal propensity to consume is 0.8, and the marginal propensity to save is 0.2.
c. The aggregate consumption function is of the form C = A + MPC × YD. We know
MPC = 0.8, so we must now solve for A. Rearranging, we have A = C - MPC × YD.
Plugging in the data from the first row of the table, we have A = $180 million -
0.8 × $100 million = $100 million. Hence, the aggregate consumption function is
C = $100 million + 0.8 × YD.

5. Statistics Canada reported, in real terms, that overall consumer spending increased by
$9.1 billion during the fourth quarter of 2010.
a. Suppose this change were due entirely to a change in autonomous consumption
and all other autonomous expenditure terms have not changed. Sketch a Keynesian
cross (planned aggregate expenditure versus GDP) diagram of the situation. Clearly
label the initial and new planned aggregate expenditure lines and the initial and
new income–expenditure equilibrium (level of) GDP.
b. If the marginal propensity to consume is 0.52, by how much will real GDP change
in response?
c. GDP at the end of the first quarter of 2011 was $1350.4 billion. If GDP were to
increase by the amount calculated in part (b), what would be the percent increase
in GDP?

Solution
5. a. The diagram below shows the rise in Planned Aggregate Expenditure associated
with a rise in autonomous spending.

Planned
aggregate
expenditure NEW AEPlanned
AE Planned

AEPlanned

Initial New Real GDP

GDP GDP

b. The change in real GDP as a result of this change in consumer spending would be:
(1/(1 − MPC)) × $9.1 billion = (1/(1 − 0.52)) × $9.1 billion = $19.0 billion.
c. The percent increase in GDP is ($19 billion/$1,350.4 billion) × 100 = 1.4%.

6. During the early 2000s, the Case-Shiller U.S. Home Price Index, a measure of average
American home prices, rose continuously until it peaked in March 2006. From March
2006 to May 2009, the index lost 32% of its value. Meanwhile, the U.S. stock market
experienced similar ups and downs. From March 2003 to October 2007, the Standard
and Poor’s 500 (S&P 500) stock index, a broad measure of stock market prices,
almost doubled, from 800.73 to a high of 1565.15. From that time until March 2009,
the index fell by almost 60%, to a low of 676.53.
a. How do you think the movements in U.S. housing prices both influenced the
growth in U.S. real GDP during the first half of the decade and added to the con-
cern about maintaining American consumer spending after the collapse in the
American housing market that began in 2006? To what extent did the movements
in the U.S. stock market hurt or help American consumer spending?

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INCOME AND EXPENDITURE 11-7

Sales will exceed firms’ expectations, firms will draw down inventories unexpect-
edly, and unplanned inventory investment will be negative.
c. A fall in the interest rate will lead to an increase in planned investment spending.
Planned aggregate spending will now exceed GDP. Sales will exceed firms’ expecta-
tions, firms will draw down inventories unexpectedly, and unplanned inventory
investment will be negative.

9. a. The accompanying table shows gross domestic product (GDP), disposable income
(YD), consumer spending (C), and planned investment spending (IPlanned) in
an economy. Assume there is no government or foreign sector in this economy.
Complete the table by calculating planned aggregate spending (AEPlanned) and
unplanned inventory investment (IUnplanned).

GDP YD C IPlanned AEPlanned IUnplanned

(billions of dollars)
$0 $0 $100 $300 ? ?
400 400 400 300 ? ?
800 800 700 300 ? ?
1,200 1,200 1,000 300 ? ?
1,600 1,600 1,300 300 ? ?
2,000 2,000 1,600 300 ? ?
2,400 2,400 1,900 300 ? ?
2,800 2,800 2,200 300 ? ?
3,200 3,200 2,500 300 ? ?

b. What is the aggregate consumption function?

c. What is Y*, income–expenditure equilibrium GDP?
d. What is the value of the multiplier?
e. If planned investment spending falls to $200 billion, what will be the new Y*?
f. If autonomous consumer spending rises to $200 billion, what will be the new Y*?

Solution
9. a.
GDP YD C IPlanned AEPlanned IUnplanned

(billions of dollars)

$0 $0 $100 $300 $400 - $400

400 400 400 300 700 - 300
800 800 700 300 1,000 - 200
1,200 1,200 1,000 300 1,300 - 100
1,600 1,600 1,300 300 1,600 0
2,000 2,000 1,600 300 1,900 100
2,400 2,400 1,900 300 2,200 200
2,800 2,800 2,200 300 2,500 300
3,200 3,200 2,500 300 2,800 400

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11-8 CHAPTER 11

b. We can find the aggregate consumption function by calculating aggregate

auton omous consumer spending and the marginal propensity to consume.
Aggregate autonomous consumer spending equals aggregate consumer spending
when disposable income is zero; in this case, aggregate autonomous consumer
spending is $100 billion. The marginal propensity to consume is the change in
aggregate consumer spending divided by the change in disposable income; in
this case, it is 0.75 [= ($400 - $100)/($400 - $0)]. The aggregate consumption
function is:
C = $100 billion + 0.75 × YD
c. Y* is the level of GDP at which planned aggregate spending equals GDP. From the
accompanying table, Y* is $1,600 billion.
d. The multiplier equals 1/(1 - MPC); the value of the multiplier is 4 = 1/(1 - 0.75).
e. If planned investment spending falls to $200 billion, the new Y* will equal $1,200
billion. If planned investment spending equals $200 billion, it has fallen by $100
billion. Since the multiplier is 4, Y* will change by four times the change in
planned investment spending, or decrease by $400 billion.
f. If autonomous consumer spending rises to $200 billion, the new Y* will equal
$2,000 billion. If autonomous consumer spending equals $200 billion, it has risen
by $100 billion. Since the multiplier is 4, Y* will change by four times the change
in autonomous consumer spending, or increase by $400 billion.

10. In an economy with no government and no foreign sectors, autonomous consumer

spending is $250 billion, planned investment spending is $350 billion, and the mar-
ginal propensity to consume is 2/3.
a. Plot the aggregate consumption function and planned aggregate spending.
b. What is unplanned inventory investment when real GDP equals $600 billion?
c. What is Y*, income–expenditure equilibrium GDP?
d. What is the value of the multiplier?
e. If planned investment spending rises to $450 billion, what will be the new Y*?

Solution
10. a. If autonomous consumer spending is $250 billion and the marginal propensity to
consume is 2⁄3, the aggregate consumption function is:
C = $250 billion + 2⁄3 × YD
Planned aggregate spending equals consumer spending plus planned investment
spending:
AEPlanned = C + IPlanned
AEPlanned = ($250 billion + 2⁄3 × YD) + $350 billion
AEPlanned = $600 billion + 2⁄3 × YD

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11-10 CHAPTER 11

Change in
IPlanned Change in Change in
or C real GDP YD

Rounds (billions of dollars)

1 DIPlanned = $10.00
2 DC = $ 5.00
3 DC = ?
4 DC = ?
5 DC = ?
6 DC = ?
7 DC = ?
8 DC = ?
9 DC = ?
10 DC = ?
$10.00 $10.00
$ 5.00 $ 5.00
? ?
? ?
? ?
? ?
? ?
? ?
? ?
? ?

a. What is the total change in real GDP after the 10 rounds? What is the value of the
multiplier? What would you expect the total change in Y * to be based on the mul-
tiplier formula? How do your answers to the first and third questions compare?
b. Redo the table starting from round 2, assuming the marginal propensity to con-
sume is 0.75. What is the total change in real GDP after 10 rounds? What is the
value of the multiplier? As the marginal propensity to consume increases, what
happens to the value of the multiplier?

Solution
11.
a. The total change in GDP after the 10 rounds is $19.98 billion, obtained by
adding up the change in GDP for each of the first 10 rounds. The multiplier is
2 [= (1/(1 - 0.5))]. We would expect the total change in Y* to be twice the change
in planned investment spending. Since the autonomous change in planned invest-
ment spending was $10 billion, we would expect a change in Y* of $20 billion. This
is very similar to the change in GDP after 10 rounds ($19.98 billion).
Change in IPlanned or C Change in real GDP Change in YD
Rounds (billions of dollars)
1 DIPlanned = $10.00 $10.00 $10.00
2 DC = 5.00 5.00 5.00
3 DC = 2.50 2.50 2.50
4 DC = 1.25 1.25 1.25
5 DC = 0.63 0.63 0.63
6 DC = 0.31 0.31 0.31
7 DC = 0.16 0.16 0.16
8 DC = 0.08 0.08 0.08
9 DC = 0.04 0.04 0.04
10 DC = 0.02 0.02 0.02

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INCOME AND EXPENDITURE 11-11

b. The total change in GDP after 10 rounds is $37.74 billion, obtained by adding up the
change in GDP for each of the first 10 rounds. The value of the multiplier is 4. As the
marginal propensity to consume increases, so does the value of the multiplier.

Change in IPlanned or C Change in real GDP Change in YD

Rounds (billions of dollars)
1 DIPlanned = $10.00 $10.00 $10.00
2 DC = 7.50 7.50 7.50
3 DC = 5.63 5.63 5.63
4 DC = 4.22 4.22 4.22
5 DC = 3.16 3.16 3.16
6 DC = 2.37 2.37 2.37
7 DC = 1.78 1.78 1.78
8 DC = 1.33 1.33 1.33
9 DC = 1.00 1.00 1.00
10 DC = 0.75 0.75 0.75

12. Although the United States is one of the richest nations in the world, it is also the
world’s largest debtor nation. We often hear that the problem is the nation’s low sav-
ings rate. Suppose policy makers attempt to rectify this by encouraging greater savings
in the economy. What effect will their successful attempts have on real GDP?

Solution
12. If policy makers successfully encouraged greater savings, there would be a decrease in
either consumer spending or planned investment spending. A drop in C or in IPlanned
would decrease the income–expenditure equilibrium GDP by several times the change
in spending. This is the paradox of thrift. If households and producers decrease spend-
ing to reduce the nation’s debt, these actions will depress the economy, leaving house-
holds and producers worse off than they were with the nation’s large debt.

13. The Canadian economy slowed significantly in 2008, and policy-makers were
extremely concerned about lack of growth. To boost the economy, the House of
Commons adopted the Economic Action Plan in January 2009. This plan delivered
about $64 billion in additional government spending into the economy. Assume,
for the sake of argument, this spending was in the form of payments made directly
to consumers. The objective was to boost the economy by increasing the disposable
income of Canadian consumers.
a. Calculate the initial change in aggregate consumer spending as a consequence of
this policy measure if the marginal propensity to consume (MPC) in Canada is
0.5. Then calculate the resulting change in real GDP arising from the $64 billion in
payments.
b. Illustrate the effect on real GDP with the use of a graph depicting the income–
expenditure equilibrium. Label the vertical axis “Planned aggregate spending,
AEPlanned” and the horizontal axis “Real GDP.” Draw two planned aggregate expen-
diture curves (AEPlanned1 and AEPlanned2) and a 45-degree line to show the effect of the
autonomous policy change on the equilibrium.

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