Problem Set 5 Answers. Marginal propensity to consume is the fraction of the increase in disposable income that is spent on consumption.

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1 Social Analysis 10 Spring 2006 Problem Set 5 Answers Question 1 (a) Marginal propensity to consume is the fraction of the increase in disposable income that is spent on consumption. Formula for MPC: MPC = Change in consumption/change in disposable income = ΔC/ ΔY D, where Y D = Y(1-Tax Rate) n year 1, Y D = 12*(0.75)=9; in year 2, Y D = 16*(0.75)=12. Hence, ΔY D = (12-9)=3 ΔC = 5-4 = 1 MPC = ΔC/ ΔY D = 1/3 = 0.33 (b) Your friend s prediction is supported by the strong form of the Permanent ncome Hypothesis, as elaborated by Milton Friedman. Friedman distinguishes between transitory and permanent changes in income. He argues that consumption changes very little, if at all, in response to a transitory change in income. According to Friedman, you will realize that your prize money represents only a transitory increase in income. Hence, you will plan to spread your consumption of the prize money over a long time, and you will only increase your current consumption very little. Your mother s prediction is supported by some economists view that consumers are not as forward-looking as Friedman thinks they are or that consumers are liquidity constrained. Consumers respond to transitory changes in income by changing their current consumption. According to these economists, you will increase your consumption significantly after receiving the prize money. (c) According to the Life Cycle Hypothesis (LCH) proposed by Franco Modigliani, individuals try to smooth their consumption path over their lifetime. Since your retirement is planned, you should have saved accordingly during the time you worked to prepare for retirement. Therefore, your consumption pattern after your retirement should be steady because you will use your savings to maintain a steady level of consumption. Your saving pattern should change from saving to dissaving because you are no longer 1

2 earning income after retirement but will be using up your savings to support your consumption during retirement. Question 2 (a) f the increase in expected inflation leads to a decrease in the real interest rate all other things being equal, investment increases and we can show the effect as a movement along the same investment demand curve. r f, instead, we assume that the increase in expected inflation happens together with an increase of the same magnitude of the nominal interest rate and the real interest rate does not change, then there is no change in investment. (b) After the release of the report, firms revise their expectations for next year real GDP. Expectations of lower real GDP reduce investment. The investment demand curve shifts to the left. 2

3 r (c) f we assume that the increase in the budget deficit does not changes agents expectations about future fiscal policy, then the higher budget deficit leads to a decrease in national savings, all other things being equal. The real interest rate increases and the quantity of investment decreases. We can show this as a movement along the curve. r Alternatively, if we assume that the increase in the budget deficit changes agents expectations about future fiscal policy, then, a higher government deficit for 2006 can, for example, signal to firms that the probability that the government in the future has to raise tax increases. This can discourage investment. The investment demand shifts to the left. 3

4 r (d) Optimisms about the state of the economy and business profitability can induce firms to invest more. nvestment demand shifts to the right. r Question 3 (a) The Aggregate Demand Curve slopes down because as the price level rises, ceteris paribus, nominal GDP increases. This increase in nominal GDP causes an increase in money demand, because people need more money in order to undertake their transactions at the higher prices. The increase in money demand causes an increase in the interest 4

5 rate, since money supply is unchanged. Holding inflationary expectations constant, the higher nominal interest rate means that the real interest rate will increase. The higher real interest rate causes a decrease in consumption demand (because we assume that the substitution effect outweighs the income effect), investment demand (because a higher interest rate reduces the Net Present Value of investment opportunities), and net exports (because the higher real interest rate raises the nominal exchange rate and thus the real exchange rate). Thus, at higher price levels, Aggregate Expenditure (ie the quantity of Aggregate Demand) is reduced, and the AD curve slopes down. (b) P LRAS SRAS P Recessionary Gap Y actual Y potential AD Y (c) Menu costs (the actual cost of changing prices) is only one of the reasons why economies have sticky prices and thus an upward sloping SRAS curve. The other reasons given in section are listed below. Any two of them would result in full credit: 1) Contract: A firm may have contracts with customers which bind it to given prices for its products for the duration of the contracts. Until the contracts expire, it cannot adjust its prices, even if demand conditions change. 2) Staggered Price Setting: Contracts do expire, and, when they do, firms can change their prices to reflect changes in demand. However, not all contracts or other price and wage commitments expire at the same time for all firms. Price setting is staggered- firms make their price decisions at different times. This can cause problems for price adjustments because firms are concerned about relative prices; if they increase their 5

6 prices while other firms do not (due to contractual obligations), their products would become relatively more expensive. Thus, firms are reluctant to change prices. 3) Coordination Failure: The problems which arise from staggered price setting stem from the fact that different firms can change prices at different times. However, even if all firms change prices at the same time, they may be hesitant to change prices until they see what other firms do. f they raise prices in response to a surge in demand, and none of their competitors follow suit, they could lose market share, and hence profits. This problem is similar to that of the Prisoner s Dilemma that we saw in the fall. 4) Customer Relations: Firms may keep prices constant because their customers don t like price changes. Newspapers, for example, have the price printed on each day, so it would be relatively costless to change prices daily. But a lot of newspaper customers (and owners of newspaper vending machines) might be annoyed if the price was 35 cents one day, 40 cents the next, and then 25 cents the next day. Hence, the newspaper is likely to remain at a constant price for long periods, even as demand fluctuates. Question 4 (a) f Economist A believes investment is less responsive to changes in real interest rates than Economist B, then Economist A s aggregate demand curve will be steeper than Economist B s. This result can be derived as follows: Consider an increase in the price level. This will increase nominal income (PY), and thus shift money demand to the right, raising nominal interest rates. Since Economists A and B agree on all of this, Economists A and B will predict the same rise in nominal interest rates. Holding inflation expectations constant, they will predict the same rise in the real interest rate as well. i Ms Md Md M 6

7 Here is where they differ. Economist A does not believe investment will respond all that much to the higher interest rates; thus, Economist A predicts only a small drop in investment. Economist B believes investment is more responsive to interest rates; thus, Economist B predicts a larger drop in investment. This could be shown with the following investment demand schedules. r d of Economist B d of Economist A nvestment nvestment is one component of aggregate expenditure. Economists A and B agree on the responses of the other components of aggregate expenditure (specifically, higher r will cause C and NX to decline). But since Economist A predicts a smaller drop in investment, she predicts a smaller drop in AE also. Thus Economist A s AD curve will be steeper. P (b) AD of Economist B AD of Economist A f investment, consumption and net exports are completely unresponsive to changes in the real interest rate, then the AD curve will be perfectly vertical. Assume the price level rises, shifting money demand to the right, and raising nominal and real interest rates, as above. But if C, and NX are completely unresponsive to this increase in the real interest rate, then aggregate expenditure will not fall at all. This gives a perfectly vertical AD curve. Y P AD Y 7

8 The book also talks about the wealth effect associated with a change in the price level. f we allow for this channel too, the increase in prices generates a negative wealth effect and consumption falls, then the AD would be negatively sloped but it would be still pretty steep and inelastic. 8