ECON 102 Tutorial 3. TA: Iain Snoddy 18 May Vancouver School of Economics

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1 ECON 102 Tutorial 3 TA: Iain Snoddy 18 May 2015 Vancouver School of Economics

2 Questions

3 Questions 1-3 set-up Y C I G X M Note: All figures in Trillion $s 3/63

4 Question 1 Table gives the aggregate expenditure schedule. Equilibrium expenditure is equal to (a) $4 Trillion (b) $3 Trillion (c) $5 Trillion (d) zero (e) $2 Trillion 4/63

5 Question 1: Calculating the Answer From this table we know output/income (Y). We can also calculate total expenditure by calculating AE = C + I + G + (X M). This gives us: Y C I G X M AE Note: All figures in Trillion $s 5/63

6 Question 1: Calculating the Answer Equilibrium occurs where output (Y) is equal to total desired spending (AE). From the table this is where output is $4 trillion. Side Note: Economists use many different definitions of equilibrium. Typically they mean the point where no person has an incentive to behave differently. Everyone is acting optimally. 6/63

7 Question 1: Answer Table gives the aggregate expenditure schedule. Equilibrium expenditure is equal to (a) $4 Trillion (b) $3 Trillion (c) $5 Trillion (d) zero (e) $2 Trillion 7/63

8 Question 2 Table gives the aggregate expenditure schedule. Marginal propensity to import is equal to (a) 0.01 (b) 0.05 (c) 0.10 (d) 0.15 (e) /63

9 Question 2: Answer The first thing to note here is that only two components change with income: imports and private consumption. This means that as output/income (Y) changes there is an induced change in C and M. The other types of expenditure have no induced component (ie they are autonomous). To calculate the MP to Import we calculate M Y. Which is.15/1 = This means that as income increases, 15 cents of every additional dollar of income is spent on foreign goods. 9/63

10 Question 2: Answer Table gives the aggregate expenditure schedule. Marginal propensity to import is equal to (a) 0.01 (b) 0.05 (c) 0.10 (d) 0.15 (e) /63

11 Question 3 Table gives the aggregate expenditure schedule. If MPC = 0.8, net tax rate is equal (a) (b) (c) (d) (e) /63

12 Question 3: The Answer So where does net tax rates enter into things? We know that households consumer a fraction of their disposable income, and that disposable income is equal to Income minus Taxes: Y D = Y T. T here is total tax paid. But normally taxes are a function of income. Normally total income tax depends upon the tax rate and the level of income you earn: T = ty. This means that Y D = Y ty. The consumption function is then C = a + MP C Y D = a + MP C (1 t)y. It is no longer true that Be very careful of this! C Y D = C Y! 12/63

13 Question 3: The Answer Instead C Y = MP C (1 t). Using the table we can calculate C Y. We also know the MPC=0.8. C Y So: C Y =.65/1 =.65. =.65 = 0.8 (1 t) (1 t) =.65.8 = t = = /63

14 Let s calculate the entire AE function (just for fun) So here is what we know: I = 0.5, G = 0.7, X = 0.45, MP I = 0.15, t = , MP C = 0.8 We also know that C = a + MP C Y D and that M = d + MP I Y. Or C = a Y D and M = d Y We can show that d = 0, when income is zero, imports are zero. Let s find a: C = a ( ) Y = a Y. Plugging in some values gives: 1 = a So a = Using AE = C + I + G + X M gives:ae = Y Y AE = Y 14/63

15 Final Check So we have the AE function AE = Y To check let s plug in some Y values and see that they give the correct value of AE. When Y=1, AE=2.5. Check When Y=2, AE=3. Check When Y=6, AE=5. Check 15/63

16 Question 3: Answer Table gives the aggregate expenditure schedule. If MPC = 0.8, net tax rate is equal (a) (b) (c) (d) (e) /63

17 Question 4 If there is a decrease in autonomous expenditure, the new AE curve is (a) flatter than the original AE curve. (b) steeper than the original AE curve. (c) parallel and above the original AE curve (d) parallel and below the original AE curve. (e) none of the above. 17/63

18 Question 4: Answer If there is a decrease in autonomous expenditure, the new AE curve is (a) flatter than the original AE curve. (b) steeper than the original AE curve. (c) parallel and above the original AE curve (d) parallel and below the original AE curve. (e) none of the above. 18/63

19 Explaining the Answer The AE function/curve takes the general form: AE = a + z Y. The slope of the curve is given by z. The Y intercept is given by a. If a changes and z does not then there is no change in the slope. A change to a only brings about a shift of the curve. 19/63

20 A review of the multiplier 1 We know that the multiplier is 1 z, and measures the change in output resulting from a change in autonomous expenditure. This change is often more than 1. (Remember last week we said the demand side is really powerful in this model). One quick check to see if the multiplier is large or small is to look at the slope of the AE function. If z is large the multiplier is large! 20/63

21 A review of the multiplier Why does a large z mean a large multiplier intuitively? The reason expenditure drives a greater than 1 increase in output is that expenditure becomes income for somebody else. This person then spends some of their income. This spending becomes income for somebody else and the process repeats. If z is larger then each round when income increases people spend more, generating a higher amount of income for others. The entire process lasts longer. 21/63

22 A review of the multiplier Let s consider a numerical example. AE = Y If autonomous expenditure increases to 200 there is an initial increase in spending of 200. This autonomous change becomes income for someone else. This then leads to further induced expenditure of $50 ( ). This $50 becomes income for someone else. This person then spends $25 dollars. The process repeats over and over. 22/63

23 A review of the multiplier This table shows the successive rounds of spending: Round Increase in Expenditure Total The rounds will keep going and eventually the total will reach z = /63

24 A review of the multiplier Another way to see the multiplier is graphically. We can draw the shift in the AE curve when spending increases AE /63

25 A review of the multiplier AE Y 25/63

26 A review of the multiplier Let s see what is moving us from one equilibrium to another AE Y 26/63

27 A review of the multiplier After the spending increase income increases AE Y 27/63

28 A review of the multiplier This generates a further increase in expenditure AE Y 28/63

29 A review of the multiplier And then an increase in income AE Y 29/63

30 A review of the multiplier And on and on AE Y 30/63

31 For the Mathy people For those interested note that the multiplier formula just comes from the geomatric sequence formula. Every round of successive spending is just the multiplier times the induce change in spending. This means the first round is The second is = 50. The third is = The fourth is = This goes on to infinity. The geometric sum of these rounds is: This is just a geometric sequence the sum of which is /63

32 Question 5 All else constant, a decrease in the income tax rate will result in (a) a movement down along the aggregate expenditure curve. (b) an upward shift of the AE curve with no change in its slope (c) a downward shift of the AE curve with no change in its slope. (d) a decrease in the consumption expenditure.. (e) an AE curve with a steeper slope. 32/63

33 Question 5: Answer All else constant, a decrease in the income tax rate will result in (a) a movement down along the aggregate expenditure curve. (b) an upward shift of the AE curve with no change in its slope (c) a downward shift of the AE curve with no change in its slope. (d) a decrease in the consumption expenditure. (e) an AE curve with a steeper slope. 33/63

34 The Answer Remember that the slope of the AE curve is given by z, ie the Marginal Propensity to Spend. We know that the MPS depends upon the tax rate and so will change with taxes. Specifically MP S = MP C (1 t) MP I So if t increases the MPS will fall. The curve will become flatter. 34/63

35 The Answer Remember that this will cause a pivot of the curve around the Y-intercept. Autonomous expenditure has not changed! AE Y 35/63

36 Question 6 Everything else remaining the same, which one of the following would increase equilibrium real GDP? (a) an increase in saving (b) an increase in exports (c) a decrease in investment (d) an increase in taxes (e) a decrease in exports 36/63

37 Question 6: Answer Everything else remaining the same, which one of the following would increase equilibrium real GDP? (a) an increase in saving (b) an increase in exports (c) a decrease in investment (d) an increase in taxes (e) a decrease in exports 37/63

38 Question 6 Answer All of the other answers will decrease expenditure, lowering real GDP. In particular a decrease in investment and exports will decrease autonomous spending. An increase in taxes will shift the AE curve downwards and lower real GDP. If saving is coming from an autonomous decrease in consumption the AE curve will shift down. If it is due to a fall in the MPC, the curve will pivot downwards. 38/63

39 Question 7 The slope of the AE curve equals (a) aggregate expenditure divided by real GDP (b) the change in aggregate expenditure divided by the change in real GDP (c) the change in consumption divided by the change in real GDP (d) the change in consumption plus government expenditure divided by the change in aggregate income (e) the change in income divided by the change in autonomous expenditure 39/63

40 Question 7: Answer The slope of the AE curve equals (a) aggregate expenditure divided by real GDP (b) the change in aggregate expenditure divided by the change in real GDP (c) the change in consumption divided by the change in real GDP (d) the change in consumption plus government expenditure divided by the change in aggregate income (e) the change in income divided by the change in autonomous expenditure 40/63

41 Question 8 The short-run aggregate supply curve indicates (a) the relationship between the price level and real GDP demanded by consumers, investors, governments, and net exporters (b) the relationship between the price level and the natural unemployment rate (c) the relationship between the purchasing power of wages and the quantity of labour supplied by households (d) the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant (e) the various quantities of real GDP producers supply at different income levels 41/63

42 Question 8 The short-run aggregate supply curve indicates (a) the relationship between the price level and real GDP demanded by consumers, investors, governments, and net exporters (b) the relationship between the price level and the natural unemployment rate (c) the relationship between the purchasing power of wages and the quantity of labour supplied by households (d) the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant (e) the various quantities of real GDP producers supply at different income levels 42/63

43 Question 9: Set-up 43/63

44 Question 9 Refer to Figure Which graph illustrates what happens when factor prices decrease? (a) a (b) b (c) c (d) d (e) a and b 44/63

45 Question 9 Refer to Figure Which graph illustrates what happens when factor prices decrease? (a) a (b) b (c) c (d) d (e) a and b 45/63

46 Question 9 Firms are now willing to supply more at every level of output as the cost of producing goods is lower. In other words, they can produce more goods at a lower price and still make a profit. 46/63

47 Question 10 Long-run aggregate supply will increase for all of the following reasons except (a) a fall in the money wage rate (b) an increase in human capital (c) the introduction of new technology (d) an increase in the full-employment quantity of labour (e) an increase in the quantity of capital 47/63

48 Question 10: Answer Long-run aggregate supply will increase for all of the following reasons except (a) a fall in the money wage rate (b) an increase in human capital (c) the introduction of new technology (d) an increase in the full-employment quantity of labour (e) an increase in the quantity of capital 48/63

49 The Long-Run in Economics The Long-run is a rather odd concept in Economics. We are never actually in the long-run! What it means is that if you were to plot data over a long time scale a particular pattern would emerge. Think of GDP fluctuating around potential. If you plot GDP over a few years it might not tell you all that much. But plotting a lot more years can give a very clear pattern. 49/63

50 The Long-Run in Economics In terms of Aggregate supply factor prices can fluctuate for many reasons. But there will be a long-run pattern to how these prices are changing based on technology and the supply and demand of these factors. In the Long-run the economy is at potential meaning that factor prices have adjusted to remove the output gap. Potential output is determined by technological progress, the labour market and capital stocks. This shift the LRAS curve. 50/63

51 The Long-Run in Economics This focus on the Long-run is the cornerstone of Neo-classical economists. These economists believe that market forces lead to the optimal equilibrium outcome eventually if left alone. Note that supply is important here. In the long run supply is what matters. This is in contrast to out short-run AE model where Demand was key. 51/63

52 Question 11 The quantity of real GDP demanded is composed of the purchases of (a) households and net exporters only (b) firms, bondholders, and net exporters only (c) firms and governments only (d) consumers, firms, governments, and net exporters (e) consumers, firms, and governments only 52/63

53 Question 11: Answer The quantity of real GDP demanded is composed of the purchases of (a) households and net exporters only (b) firms, bondholders, and net exporters only (c) firms and governments only (d) consumers, firms, governments, and net exporters (e) consumers, firms, and governments only 53/63

54 Question 11: Answer Remember that the demand curve is derived form the AE model. Each point on the demand curve represents the equilibrium level of expenditure/purchases that would take place given the price level. As the price falls people buy less, the AE curve shifts down and output falls. This is the logic behind the downward sloping AD curve. 54/63

55 Question 12 If the price level rises, then the wealth effect leads to (a) an increase in real wealth, an increase in current consumption expenditure, and an increase in saving (b) an increase in real wealth, an increase in current consumption expenditure, and a decrease in saving (c) a decrease in real wealth, an increase in current consumption expenditure, and an increase in saving (d) a decrease in real wealth, an increase in current consumption expenditure, and a decrease in saving (e) a decrease in real wealth, a decrease in current consumption expenditure, and an increase in saving 55/63

56 The Wealth Effect The Wealth Effect The wealth effect states that individuals will consume less if they perceive a decrease in their wealth 56/63

57 Question 12 If the price level rises, then the wealth effect leads to (a) an increase in real wealth, an increase in current consumption expenditure, and an increase in saving (b) an increase in real wealth, an increase in current consumption expenditure, and a decrease in saving (c) a decrease in real wealth, an increase in current consumption expenditure, and an increase in saving (d) a decrease in real wealth, an increase in current consumption expenditure, and a decrease in saving (e) a decrease in real wealth, a decrease in current consumption expenditure, and an increase in saving 57/63

58 Question 13 When the economy of Econoworld is in short-run Macroeconomic equilibrium, the price level is (a) 100 (b) 90 (c) 75 (d) 70 (e) 85 58/63

59 Question 13: Answer When the economy of Econoworld is in short-run Macroeconomic equilibrium, the price level is (a) 100 (b) 90 (c) 75 (d) 70 (e) 85 59/63

60 Question 14 If Econoworld automatically adjusts to a long-run equilibrium, then in the long-run macroeconomic equilibrium (a) the price level is 70 (b) real GDP is $440 billion (c) actual unemployment exceeds the natural unemployment rate (d) potential GDP is greater than in the short run (e) both A and B 60/63

61 Question 14: Answer If Econoworld automatically adjusts to a long-run equilibrium, then in the long-run macroeconomic equilibrium (a) the price level is 70 (b) real GDP is $440 billion (c) actual unemployment exceeds the natural unemployment rate (d) potential GDP is greater than in the short run (e) both A and B 61/63

62 Question 14: Answer Long-run adjustment takes place through factor-price adjustment. This means that wages and rents adjust to return the economy to long-run equilibrium. Here there is a recessionary gap. This means there is an excess supply of factors of production. The price of these factors will fall and so the supply curve will shift to the right. 62/63

63 That s it Good luck on the Midterm! 63/63

Economics 1012A: Introduction to Macroeconomics FALL 2007 Dr. R. E. Mueller Third Midterm Examination November 15, 2007

Economics 1012A: Introduction to Macroeconomics FALL 2007 Dr. R. E. Mueller Third Midterm Examination November 15, 2007 Answer all of the following questions by selecting the most appropriate answer on