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Chapter 10 - Basic Macroeconomic Relationships
Short Answer Questions
206. Define the consumption and saving schedules.
In the aggregate expenditures model one focus is on the consumption schedule which is the
relationship between the consumption part of aggregate expenditures and disposable income.
Graphically this relationship is illustrated with consumption measured on the vertical axis and
disposable income measured on the horizontal axis. If the two were equal, the relationship
would follow a straight line along the 45-degree line. Historical data and the aggregate
expenditures model suggest that it is a direct relationship, and that households spend a larger
proportion of a small income than of a large disposable income. In other words, consumption
as a proportion of income falls as disposable income increases.
Since saving is the difference between disposable income and consumption spending, the
saving schedule also shows a direct relationship between saving and disposable income.
Graphically, it is depicted with saving on the vertical axis and disposable income measured on
the horizontal axis. At very low income levels, dissaving is believed to occur and saving
increases proportionally as income rises.
Accessibility: Keyboard Navigation

Difficulty: Easy
Learning Objective: 10-01 Describe how changes in income affect consumption (and saving).
Topic: 10-01 The Income-Consumption and Income-Saving Relationships
207. Explain how consumption and saving are related to disposable income.
Consumption and saving are directly related to disposable income. Consumption is positively
related to disposable income, but is a proportionally greater part of low income than of high
income. In fact, at very low income levels it is probable that consumption exceeds income.
Since saving is income not spent, it is also directly related to income and will be an increasing
proportion of income as income rises. At very low levels of income when consumption
exceeds income, saving will be negative or dissaving occurs.

Difficulty: Medium
10-1
208. Complete the following table assuming that (a) MPS = 1/5, (b) there is no government
and all saving is personal saving.
Level of output and income Consumption Saving

$250 $260 $_____
275 _____
300 _____ _____
325 _____ _____
350 _____ _____
375 _____ _____
400 _____ _____
Income Consumption Savings

250 260 -10
275 280 -5
300 300 0
325 320 5
350 340 10
375 360 15
400 380 20

Difficulty: Medium
209. Complete the following table assuming that (a) MPS = 1/3, (b) there is no government
and all saving is personal saving.
10-2
Level of output and income Consumption Saving

$100 $120 $_____
130 _____
160 _____ _____
190 _____ _____
220 _____ _____
250 _____ _____
Income Consumption Savings

100 120 -20
130 140 -10
160 160 0
190 180 10
220 200 20
250 220 30
10-3

Difficulty: Medium
210. Differentiate between the average propensity to consume and the marginal propensity to
consume.
The average propensity to consume is defined as the relationship between the amount
consumed relative to the level of income; it is (consumption)/(income). The marginal
propensity to consume is a measure relating the change in consumption resulting from a
change in income to that change in income; it is (change in consumption)/(change in income).

Difficulty: Easy
Topic: 10-04 Average and Marginal Propensities
211. What are the marginal propensity to consume (MPC) and marginal propensity to save
(MPS)? How are the two concepts related? How are the two concepts related to the
consumption and saving functions?
The marginal propensity to consume is the ratio of a change in consumption to the change in
income, which caused that change in consumption. The marginal propensity to save is the
ratio of the change in saving to the change in income, which caused that change in saving.
The sum of the MPC and MPS for any change in disposable income must always equal 1
because any fraction of a change in income that is not consumed is saved. The MPC is the
numerical value of the slope of the consumption schedule and the MPS is the numerical value
of the slope of the saving schedule.

Difficulty: Medium
10-4
212. Suppose a family's annual disposable income is $8,000 of which it saves $2,000.
(a) What is their APC?

(b) If their income rises to $10,000 and they plan to save $2,800, what are their MPS and
MPC?
(c) Did the family's APC rise or fall with their increase in income?
(a) APC = .75 ($6,000/$8,000).

(b) MPS = .4 ($800/$2,000); MPC = .6 (1 - .4).
(c) APC fell to.72 ($7,200/$10,000).

Difficulty: Medium
213. Complete the accompanying table.
Level of
output and
income
(GDP = Consumption Saving APC APS MPC MPS
DI)
$480 $_____ $-8 _____ _____ _____ _____
520 _____ 0 _____ _____ _____ _____
560 _____ 8 _____ _____ _____ _____
600 _____ 16 _____ _____ _____ _____
640 _____ 24 _____ _____ _____ _____
680 _____ 32 _____ _____ _____ _____
720 _____ 40 _____ _____ _____ _____
760 _____ 48 _____ _____ _____ _____
800 _____ 56 _____ _____ _____ _____
10-5
Using the below graphs, show the consumption and saving schedules graphically.
(b) Locate the break-even level of income. How is it possible for households to dissave at
very low income levels?
(c) If the proportion of total income consumed decreases and the proportion saved increases
as income rises, explain both verbally and graphically how the MPC and MPS can be constant
at various levels of income.
(b) The break-even level of income is 520 where saving equals zero. Households dissave by
borrowing or by dipping into accumulated savings.
(c) The MPC and MPS represent the slopes of the consumption and savings schedules
respectively. The fact that MPC and MPS are constant means that the schedules will be
straight-line graphs. However, the slope can be constant and still not be a constant proportion
of income as represented on the horizontal axis. In fact, the only time the MPC and the APC
would be the same would be along lines emanating from the origin.
10-6
10-7
Difficulty: Medium
214. Complete the accompanying table.
Level of
output and
income
(GDP = Consumption Saving APC APS MPC MPS
DI)
$100 $_____ $-5 _____ _____ _____ _____
125 _____ 0 _____ _____ _____ _____
150 _____ 5 _____ _____ _____ _____
175 _____ 10 _____ _____ _____ _____
200 _____ 15 _____ _____ _____ _____
225 _____ 20 _____ _____ _____ _____
250 _____ 25 _____ _____ _____ _____
275 _____ 30 _____ _____ _____ _____
300 _____ 35 _____ _____ _____ _____
10-8
(a) What is the break-even level of income? How is it possible for households to dissave at
very low income levels?
(b) If the proportion of total income consumed decreases and the proportion saved increases
as income rises, explain how the MPC and MPS can be constant at various levels of income.
a) The break-even level of income is 125 where saving equals zero. Households dissave by
borrowing or by dipping into accumulated savings.
(b) The MPC and MPS represent the slopes of the consumption and savings schedules,
respectively. The fact that MPC and MPS are constant means that the schedules will be
straight-line graphs. However, the slope can be constant and still not be a constant proportion
of income as represented on the horizontal axis. In fact, the only time the MPC and the APC
would be the same would be along the 45-degree line where the slope is equal to 1 and the
ratio of spending to income is equal to 1 at all levels.

Difficulty: Medium
215. Suppose that the linear equation for consumption in a hypothetical economy is C = 50 +
0.9 Y. Also suppose that income (Y) is $400. Determine the following: (a) MPC; (b) MPS; (c)
level of consumption; (d) APC; (e) APS.
(a) MPC = 0.9. (b) MPS = 0.1. (c) At Y = $400, C = $410. (d) At Y = $400, APC =
$410/$400 = 1.025. (e) At Y = $400, APS = -$10/$400 = -0.025.

Difficulty: Medium
10-9
216. List four factors that could shift the current consumption schedule.
Shifts in the current consumption schedule could be caused by any of the non-income
determinants of consumption and saving. The consumption schedule would shift upward if
wealth increases, if households borrow more (e.g., due to lower real interest rates), if they
expect higher future prices or increase in future incomes, -and if real interest rates fall.

Difficulty: Medium
Learning Objective: 10-02 List and explain factors other than income that can affect consumption.
Topic: 10-05 APC and APS
217. What is the effect of increase in wealth on the consumption and saving schedules?
When wealth increases, it shifts the consumption schedule upward as people consume more at
each level of disposable income. There is an opposite effect on saving. The saving schedule
shifts downward at each level of disposable income because people save less.

Difficulty: Easy
218. Explain the difference between a movement along the consumption schedule and a shift
in the consumption schedule.
A movement from one point to another on the consumption schedule is a change in the
amount consumed. It is caused solely by a change in disposable income. By contrast, a shift in
the consumption schedule is the result of a change in one of the non-income determinates of
consumption such as a change in wealth, expectations, borrowing, or real interest rates. If a
household decided to consume more at each level of disposable income, the consumption
schedule will shift upward.

Difficulty: Medium
10-10
219. Use the graphs below to answer the following questions:
(a) What types of schedules do graphs A and B represent?

(b) If in graph A line A2 shifts to A3 because households consume more and this change is
not due to changing taxes, then what would happen to line B2 in graph B?
(c) If in graph B, line B2 shifts to B1 because households save less, then what will happen to
line A2 in graph A?
(d) In graph A, what has caused the movement from point A to point B on line A2?
(e) If there is a lump-sum tax increase causing line A2 to shift to A1, then in graph B, what
will happen to B2?
(a) Graph A represents the consumption schedule and B represents the saving schedule.
(b) If consumption rises at each level of income, then saving must decline at each level so B2
will shift down.
(c) The situation is the reverse of part (b). Line A2 would shift to A3 if B2 shifts to B1.
Consumption rises when saving falls.
(d) Since it is a movement along the curve rather than a shift in the curve, the level of
disposable income must have increased.
(e) A tax increase will lower both consumption and saving schedules because disposable
income has been reduced at each level of output.
Difficulty: Medium
Topic: 10-02 The Consumption Schedule
10-11
220. Describe the relationship between the Great Recession of 2008-2009 and the Paradox of
Thrift.
The Great Recession of 2008-2009 altered the prior consumption and saving behaviour in the
economy. Concerned about reduced wealth, high debt, and potential job losses, households
increased their saving and reduced their consumption at each level of after-tax income (or
each level of GDP). This outcome can be illustrated with the downward shift of the
consumption schedule and the upward shift of the saving schedule. This change of behaviour
illustrates the so-called paradox of thrift, which refers to the possibility that a recession can be
made worse when households become more thrifty and save in response to the downturn.

Difficulty: Medium
Topic: 10-06 MPC and MPS
221. Describe the relationship shown by the investment demand curve.
The investment demand curve relates investment to the real rate of interest and the expected
rate of return. Graphically the interest rate and expected rate of return are measured on the
vertical axis and the amount of investment is measured on the horizontal axis. The investment
demand curve has a negative slope reflecting the inverse relationship between the interest rate
(the price of investing) and the aggregate quantity of investment goods demanded.

Difficulty: Medium
Learning Objective: 10-03 Explain how changes in real interest rates affect investment.
Topic: 10-07 MPC and MPS as Slopes
10-12
222. Use the following data to answer the questions.
Expected rate of return Cumulative amount of investment (billions)

11% $55
10 75
8 90
5 105
3 150
1 190
(a) Explain why this table is essentially an investment demand schedule.

(b) If the interest rate was 8%, how much investment would be undertaken?
(c) Why is there an inverse relationship between the rate of interest and the amount of
investment?
(a) The investment demand schedule gives the amount of investment that would be
undertaken at various rates of interest. The rate of interest that an investor would be willing to
pay for any amount of investment will not exceed its expected rate of net profit. Therefore,
the expected rate of profit determines the interest rate (or price) that investors would be
willing to pay for various amounts of investment and this is the definition of an investment
demand schedule.
(b) Investment is $90 billion.
(c) The inverse relationship stems from the equality of the expected rate of profit with the
interest rate at each level of investment as explained in part (a). There are fewer types of
investment that yield a large expected net profit and more and more investments that will
yield a lower rate of return. Therefore, at high rates of interest there is a smaller amount of
investment that will be undertaken because fewer investments yield an expected return high
enough to cover the high interest rate. As the rate declines, more and more investments will
yield enough return to cover the lower rates of interest.

Difficulty: Medium
Learning Objective: 10-03 Explain how changes in real interest rates affect investment.
Topic: 10-07 MPC and MPS as Slopes
10-13
223. List six events that could cause a shift in the investment demand curve to the right.
The investment demand curve would shift to the right if the cost of acquiring, operating, or
maintaining capital goods declined; business taxes decreased; a technological change favoring
new investment occurred; the stock of capital goods on hand relative to sales decreased; firms'
decided to increase inventories; or expectations about higher future profits from investment
increased.

Difficulty: Medium
Learning Objective: 10-04 Identify and explain factors other than the real interest rate that can affect investment.
Topic: 10-11 Expectations
224. State four factors that explain why investment spending tends to be unstable.
Investment spending is based to a large extent on expectations about future profitability and
this can vary significantly from period to period. Technological changes affect investment
spending and these changes are not predictable in their timing. Investment goods tend to be
long lasting and "lumpy" in nature; that is, once a capital good is purchased it lasts a long time
and the expenditure will not be repeated on a frequent, regular basis. Furthermore, this type of
expenditure is usually large, so any changes tend to be substantial on a firm-by-firm basis.
Expectations and profits are both highly variable. Actual profits may not meet expectations
and this can affect expectations in the future. Expectations are also based on many different
external factors. Also, since firms may finance investment out of profits, variability in profits
will lead to instability in investment.

Difficulty: Medium
Topic: 10-12 Real Interest Rates
10-14
225. Describe the relationship between the Great Recession of 2008-2009 and the Investment
Riddle.
During the Great Recession of 2008-2009, real interest rates declined essentially to zero. This
drop in interest rates should have boosted investment spending. But gross fixed investment
declined substantially—by 16 percent—between 2008 and 2009, and hence this phenomenon
is called the Investment Riddle. The key to the investment riddle is that during the recession
the investment demand curve shifted inward so much that this shift overwhelmed any
investment-increasing effects of the decline of real interest rates. The net result turned out to
be less investment, not more. The leftward shift of the investment demand reflected a decline
in the expected returns from investment.

Difficulty: Medium
10-15
226. Most economists regard investment demand as being less stable than the income-
consumption relationship. Looking at the determinants of the two relationships, support this
contention.
The non- income determinants of the income-consumption relationship are consumer wealth,
borrowing based on real interest rates, price and income expectations, and personal taxes. For
a given real interest rate, determinants of investment are the price of investment goods and
their maintenance and operating costs, business taxes, technological change, stock of capital
goods on hand, and expectations. Comparing the two lists there are some similarities. For
example, both include expectations, related price levels, and relevant taxes. However, the
technological change and the stock of capital goods on hand have no analogy in the
consumption determinants.
These latter two determinants of investment support the contention of economists that the
investment demand relationship is more unstable than the income-consumption relationship.
Technological change is difficult to predict and certainly its impact would vary depending on
the extent of the change. The stock of capital goods on hand is a result of previous investment
and because of the nature of most capital goods, they can be made to last for a long period of
time. Once new capital spending occurs, it is "lumpy" in the sense that it will not be repeated
gradually, but only again when the particular capital good wears out or becomes obsolete.
Only the durable goods component of consumption is similar, but most of consumer spending
is of the more immediate type such as nondurable goods and services, which are primarily
related to income and would not vary greatly from period to period for most consumers.
The basic determinant of consumption is the level of income, but non-income factors include
wealth, borrowing, expectations, and taxation. Aside from a drastic change in government tax
or transfer policies, the income-consumption relationship is quite stable. That is, changes in
disposable income are accompanied by predictable changes in consumption spending.
Furthermore the other factors are quite diverse and tend to be self-cancelling across the
population.
The two basic factors determining the level of investment spending are the expected rate
return and the real interest rate. Since the former is based on expectations and the latter based
to a large extent on monetary policy, there is potential for wide variation. Add to this the fact
that investment goods are usually quite durable, and new investment can be postponed
depending on expectations, or once it is made there will be a period of time before the new
capital goods will need to be replaced. Also the fact that innovations occur irregularly leads to
the inability to plan for gradual investment in innovative technology. Finally, actual current
profits are often not as expected, so businesses can be expected to shift their investment plans
from year to year.

Difficulty: Medium
10-16
227. Define the multiplier. How is it related to real GDP and the initial change in spending?
How can the multiplier have a negative effect?
The multiplier is simply the ratio of the change in real GDP to the initial change in spending.
Multiplying the initial change in spending by the multiplier gives you the amount of change in
real GDP. The multiplier effect can work in a positive or a negative direction. An initial
increase in spending will result in a larger increase in real GDP, and an initial decrease in
spending will result in a larger decrease in real GDP.

Difficulty: Easy
Learning Objective: 10-05 Illustrate how changes in investment (or one of the components of total spending) increase or decrease real GDP
by a multiple amount.
Topic: 10-13 Other Important Considerations
228. Explain the economic impact of an increase in the multiplier.
The multiplier magnifies the fluctuations in economic activity initiated by changes in

consumption and investment spending. The larger the multiplier the greater will be the impact
of any changes in spending on real GDP.

Difficulty: Easy
Topic: 10-13 Other Important Considerations
10-17
229. What are two key facts that serve as the rationale for the multiplier effect?
First, the economy has continuous flows of expenditures and income in which income
received by one person comes from money spent by another person who in turn receives
income from the spending of another person, and so forth. Second, any change in income will
cause both consumption and saving to vary in the same direction as the initial change in
income, and by a fraction of that change. The fraction of the change in income that is spent is
called the marginal propensity to consume (MPC). The fraction of the change in income that
is saved is called the marginal propensity to save (MPS). The significance of the multiplier is
that a small change in investment plans or consumption-saving plans can trigger a much
larger change in the equilibrium level of GDP.

Difficulty: Medium
Topic: 10-14 The Interest Rate-Investment Relationship
230. What are the relationships between the multiplier and the marginal propensities to
consume and save?
By definition, the multiplier is related to the marginal propensity to save because it equals
1/MPS. Thus, the multiplier and the MPS are inversely related. The multiplier is also related
to the marginal propensity to consume because it also equals 1/(1-MPC).

Difficulty: Easy
Topic: 10-15 Expected Rate of Return
10-18
231. Describe the relationship between the size of the MPC and the multiplier. How does it
compare to the relationship between the size of the MPS and the multiplier?
The size of the MPC and the multiplier are directly related. The size of the MPS and the
multiplier are inversely related. In equation form, the multiplier = 1/MPS or the multiplier =
1/(1-MPC).

Difficulty: Medium
Topic: 10-15 Expected Rate of Return
10-19
232. Describe and explain how the Great Recession altered the prior consumption and saving
behavior in the economy.
The Great Recession of 2008-2009 altered the prior consumption and saving behaviour in the
economy. Concerned about reduced wealth, high debt, and potential job losses, households
increased their saving and reduced their consumption at each level of after-tax income (or
each level of GDP). In Figure 10-4, this outcome is illustrated as the downward shift of the
consumption schedule in the top graph and the upward shift of the saving schedule in the
lower graph.
This change of behaviour illustrates the so-called , which refers to the possibility that a
recession can be made worse when households become more thrifty and save in response to
the downturn. The paradox of thrift rests on two major ironies.
One irony is that saving more is good for the economy in the long run, as noted in Chapter 1.
It finances investment and therefore fuels subsequent economic growth. But saving more can
be bad for the economy during a recession, when the increased saving is not likely to be
matched by an equal amount of added investment because firms are pessimistic about future
sales. The extra saving, then, simply reduces spending on currently produced goods and
services. That means that even more businesses suffer, more layoffs occur, and people's
incomes decline even more.
The paradox of thrift has a second irony related to the fallacy of composition (Chapter 1, Last
Word): Households as a group may inadvertently end up saving less when each individual
household tries to save more during a recession. This is because each household's attempt to
save more implies that it is also attempting to spend less. Across all households, that
collective reduction in total spending in the economy creates more job losses and further
drives down total income. The decline in total income reduces the ability of households as a
group to save as much as they did before their spending reduction and subsequent income
declines.

Difficulty: Medium
Topic: 10-16 The Real Interest Rate
10-20
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Short Answer Questions

206. Define the consumption and saving schedules.

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Level of output and income Consumption Saving

Income Consumption Savings

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Level of output and income Consumption Saving

Income Consumption Savings

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(a) What is their APC?

(a) APC = .75 ($6,000/$8,000).

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213. Complete the accompanying table.

214. Complete the accompanying table.

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219. Use the graphs below to answer the following questions:

(a) What types of schedules do graphs A and B represent?

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221. Describe the relationship shown by the investment demand curve.

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222. Use the following data to answer the questions.

Expected rate of return Cumulative amount of investment (billions)

(a) Explain why this table is essentially an investment demand schedule.

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228. Explain the economic impact of an increase in the multiplier.

The multiplier magnifies the fluctuations in economic activity initiated by changes in

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