CHAPTER 24 Basic Macroeconomic Relationships

CHAPTER 24 Basic Macroeconomic Relationships Answers to Short-Answer, Essays, and Problems 1. What are the relationships among consumption, saving, and disposable income? Disposable income equals consumption plus saving. If consumption is less than disposable income, the difference is saving. There is a positive or direct relationship between consumption and disposable income (after-tax income) because as disposable income increases so does consumption. There is a positive relationship between saving and disposable income because as disposable income rises so does saving. Disposable income is the most important determinant of both consumption and saving. 2. Describe the consumption schedule. The consumption schedule shows the relationship between the consumption 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. However, historical data 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 falls as a proportion of income as disposable income increases. 3. Describe the saving schedule. Saving is the difference between disposable income and consumption spending. The saving schedule 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. 4. Explain how consumption and saving are related to disposable income in the aggregate expenditures model. Consumption and saving are directly related to disposable income in the aggregate expenditures model. 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. 5. Fill in the table below. Describe your result. Disposable Income Consumption Saving $200 $210 $ $ $220 $0 $ $230 $10 $260 $ $20 $280 $ $30 $300 $260 $

Chapter 24 Disposable Income Consumption Saving $200 $210 $20 $220 $220 $0 $240 $230 $10 $260 $240 $20 $280 $250 $30 $300 $260 $40 At the lowest levels of income, dissaving occurs as households spend more than they receive in disposable income. This dissaving could occur with households liquidating their assets or borrowing money. As income rises we see that savings increases by a greater and greater amount. This increase could occur because higher incomes make households more able to save or the importance of saving to households increases as income rises. 6. Complete the following table assuming that (a) MPS = 1/5, (b) there is no government and all saving is personal saving. and income Consumption Saving $250 $260 $ 275 300 325 350 375 400 and income Consumption Saving $250 $260 $10 275 280 5 300 300 0 325 320 5 350 340 10 375 360 15 400 380 20 7. Complete the following table assuming that (a) MPS = 1/3, (b) there is no government and all saving is personal saving. and income Consumption Saving $100 $120 $ 130 160 190 220 250

Basic Macroeconomic Relationships and income Consumption Saving $100 $120 $20 130 140 10 160 160 0 190 180 10 220 200 20 250 220 30 8. Differentiate between the average propensity to consume and the marginal propensity to consume. The average propensity to consume is defined as the relationship of the amount consumed 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). 9. 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 which 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. 10. If you know the marginal propensity to consume you can determine the marginal propensity to save. How is that possible? The marginal propensities sum to 1 (MPC + MPS = 1). Thus, if you know the value of one marginal propensity (e.g., MPC), you can always figure out the other marginal propensity (e.g., 1 MPC = MPS). 11. If you know the average propensity to consume you can determine the average propensity to save. How is that possible? The average propensities sum to 1 (APC + APS = 1). Thus, if you know the value of one average propensity (e.g., APC), you can always figure out the other average propensity (e.g., 1 APC = APS). 12. Suppose a family s annual disposable income is $8000 of which it saves $2000. (a) What is their APC? (b) If income rises to $10,000 and they plan to save $2800, what are MPS and MPC? (c) Did the family s APC rise or fall with their increase in income? (a) APC = 0.75; (b) MPS = 0.4; MPC = 0.6; (c) APC fell to 0.72.

Chapter 24 13. Complete the accompanying table. and income (GDP = DI) Consumption Saving APC APS MPC MPS $100 $ $5 125 0 150 5 175 10 200 15 225 20 250 25 275 30 300 35 (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. and income (GDP = DI) Consumption Saving APC APS MPC MPS $100 $105 $5 1.05.05 0.8 0.2 125 125 0 1.00.00 0.8 0.2 150 145 5 0.97.03 0.8 0.2 175 165 10 0.94.06 0.8 0.2 200 185 15 0.925.075 0.8 0.2 225 205 20 0.91.09 0.8 0.2 250 225 25 0.90.10 0.8 0.2 275 245 30 0.89.11 0.8 0.2 300 265 35 0.88.12 0.8 0.2 (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.

Basic Macroeconomic Relationships 14. Complete the accompanying table. and income (GDP = DI) Consumption Saving APC APS MPC MPS $480 $ $8 520 0 560 8 600 16 640 24 680 32 720 40 760 48 800 56 (a) 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. and income (GDP = DI) Consumption Saving APC APS MPC MPS $480 $488 $8 1.02 0.2 0.8 0.2 520 520 0 1.00 0.0 0.8 0.2 560 552 8 0.99 0.1 0.8 0.2 600 584 16 0.99 0.3 0.8 0.2 640 616 24 0.96 0.4 0.8 0.2 680 648 32 0.95 0.5 0.8 0.2 720 680 40 0.94 0.6 0.8 0.2 760 712 48 0.94 0.6 0.8 0.2 800 744 56 0.93 0.7 0.8 0.2 (a) See graphs. 493

Chapter 24 (b) The break-even level of income is 520 where saving equals zero. Households dissave by borrowing or by dipping into accumulated savings. [text: E pp. 549-551; MA pp. 193-195] (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. 15. List four factors that could shift the consumption schedule. Shifts in the consumption schedule could be caused by any of the nonincome determinants of consumption and saving. This includes changes in any of the following: wealth, expectations, real interest rates, and household borrowing. 16. Define wealth. What is the effect of increase in wealth on the consumption and saving schedules? The wealth of a household is the difference between the assets that it owns and the dollar amount of its liabilities. 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. 17. How does increased household borrowing affect present and future consumption? Increased borrowing will increase current consumption possibilities, which shift the consumption schedule upward. But borrowing reduces wealth by increasing debt, which in turn reduces future consumption possibilities because the borrowed money must be repaid. 18. Suppose that real interest rates increase. What would be the likely effect on household consumption and saving? A rise in real interest rates would raise the price of borrowing for households, so consumption would likely decline, especially consumption of products usually bought on credit such as homes and automobiles. A rise in interest rates increases the rate of return earned on savings, making saving more attractive, so savings would likely increase. 19. Other things being constant, what will be the effect of each of the following on disposable income (or real GDP)? (a) An increase in the amount of liquid assets consumers are holding (b) A sharp rise in stock prices (c) A rapid upsurge in the rate of technological advance (d) A sharp increase in the real interest rate (a) This should increase disposable income because an increase in consumer wealth would lead to an increase in consumer spending which would shift the consumption schedule upward to a higher equilibrium output level. (b) The probable effect of a sharp rise in stock prices would be to increase shareholder purchases as a result of a rise in wealth, thus shifting the consumption schedule upward and increasing the equilibrium level of GDP. It also could encourage business investment with funds gained by issuing new shares of stock at the now higher prices. This would also tend to increase GDP. (c) This should increase GDP because of the impact on new investment spending and possible increased consumer purchases of goods having the new technology. The consumption schedule will shift upward and real quantity will rise. (d) A sharp increase in the real interest rate would limit consumer durables purchases and also limit investment spending. Both of these events would cause a downward shift in the consumption schedule

Basic Macroeconomic Relationships causing a decrease in GDP. One could even argue that higher real interest rates raise production costs and shift the aggregate supply curve leftward as well, further leading to the GDP decline. 20. Other things being constant, what will be the effect of each of the following on consumption and saving schedules? (a) Credit card companies increase the interest-free periods on their cards to compete for customers. (b) Concern grows over rising prices. (c) A weakening of the housing market lowers home values. (d) Real interest rates fall. (e) Congress officially approves the President s plan for tax cuts. (a) An extension of interest-free periods on credit cards makes credit cheaper for households, so household borrowing will increase. This increase will cause the consumption schedule to shift upward, as households can afford to consume more. Correspondingly the savings schedule would shift downward. (b) Expectations of rising prices would likely increase current consumption, as expected returns on savings decrease due to expected future inflation. This means that the consumption schedule would shift up and the savings schedule would shift down. (c) A reduction of housing prices lowers household wealth, reducing consumption and promoting savings. This will cause the consumption schedule to shift downward and the savings schedule to shift upward. (d) A reduction in real interest rates decreases the cost of borrowing, so borrowing and subsequently consumption will increase, shifting the consumption schedule upward. Lower real interest rates decrease the attractiveness of savings, causing savings to decline and the savings schedule to shift downward. (e) A cut in taxes increases household funds available for both savings and consumption, meaning that both the consumption and saving schedules will shift upward. 21. 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 nonincome determinates of consumption such as a change in wealth, expectations, taxation, or household borrowing. If a household decided to consume more at each level of disposable income, the consumption schedule will shift upward. 22. 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 A 2 shifts to A 3 because households consume more and this change is not due to changing taxes, then in graph B, what would happen to line B 2? (c) If in graph B, line B 2 shifts to B 1 because households save less, then in graph A, what will happen to line A 2? (d) In graph A, what has caused the movement from point A to point B on line A 2?

Chapter 24 (e) If there is a lump-sum tax increase causing line A 2 to shift to A 1, then in graph B, what will happen to B 2? (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 B 2 will shift down. (c) The situation is the reverse of part (b). Line A 2 would rise if B 2 falls. 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. 23. (Consider This) Use the Great Recession of 2007 2009 to describe the paradox of thrift. During the Great Recession of 2007 2009 there was a reverse wealth effect because as wealth declined during the recession, people consumed less and saved more. Such a situation creates a paradox of thrift in which more saving helps individual household budgets, but as people cut back on their consumption and increase their saving, the collective effect on the economy is an adverse one that worsened the recession. 24. 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. 25. Consider the following investment situations. (a) A local bookseller is considering expanding store space to increase his capacity for books. The rent for the additional space would cost $3000 per year. The bookseller predicts that the added space will pull in an additional profit of $4000 per year. The current interest rate is 12%. Should the bookseller invest in the extra space? (b) A baker is considering expanding her business by adding an additional oven to her kitchen. The new oven would cost $700. The baker expects the new oven to bring in additional profits of $800. The baker can borrow at a nominal interest rate of 15% and the current inflation rate is 4%. Should she make the investment? (c) A mechanic is considering expanding his garage. After a strong year last year, the mechanic is able to finance the expansion from last year s profits. The expansion itself is expected to cost $11,000. The

Basic Macroeconomic Relationships mechanic estimates that the additional garage will bring in revenue totaling $12,000. The mechanic is currently receiving an interest rate of 8% on his saved profits. Should he make the investment? (a) Yes. The additional space would bring a profit of $1000 or an expected rate of return of 33.3% compared to the marginal cost of a 12% interest rate. The total rate of return for the project would be 21.3%, a substantial return on his investment. (b) Yes. The new oven would bring additional profits of $100 or an expected rate of return of 14.3% the first year of operation. Though the nominal interest rate to borrow is greater than the rate of return at 15%, when adjusted for inflation the real interest rate is only 11%. This would bring a total return of 3.3% and thus the baker should invest in the new oven. (c) No. Though the expansion would appear to have an expected profit of $1000 or rate of return of 9.1%, the mechanic needs to account for the opportunity cost of not saving his profits at an interest rate of 8%. This opportunity cost would be lost returns of $880 ($11,000 8%). This brings the total cost of the expansion to $11,880. Total profits are then only $120 or a rate of return of 1.01%. The mechanic should not make the investment. 26. 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) $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. 27. What is the investment demand curve? The investment-demand curve shows the relationship between the real interest rate and the level of investment spending. The relationship is an inverse one the lower the interest rate, the greater the investment spending which means that the investment-demand curve is downsloping. This curve can also be shifted by six factors that can change the expected rate of return on investment.

Chapter 24 28. List six events that could cause a shift in the investment demand curve. Six events would result from changes in the determinants of investment demand. For example, changes in the price, cost of operation, or maintenance of particular investment goods could cause the curve to shift; changes in business taxes favoring or penalizing investment could cause it to shift; a technological change favoring new investment could cause a shift; changes in the stock of capital goods on hand will cause the existing demand curve to shift; planned changes that firms desire to make to their inventory levels will cause the investment demand curve to shift; and changing expectations about future profits from investment would have an effect. 29. How will the following situations affect the investment demand curve? (a) A new type of engine is developed that is more fuel efficient. (b) To lessen the fiscal deficit, Congress increases corporate taxes. (c) Unplanned inventories rise to new highs. (d) A firm decides to increase its current inventory levels. (a) This technological advance will shift the investment demand curve outward. A more fuel efficient engine will help companies save money on fuel costs, allowing them to invest more in other areas. (b) Higher taxes on businesses will leave them less money to invest in projects and the investment demand curve will shift inward. (c) A high level of unplanned inventories means that firms have a large stock of capital goods and thus have little incentive to invest in more capital goods, so investment will decline and the investment demand curve will shift inward. (d) The decision made by the firm will have a positive effect on current investment and shift the investment demand curve to the right. 30. Contrast planned and unplanned inventory changes. What effect do these changes have on the investment demand curve? The difference between planned and unplanned inventory changes is whether or not a firm makes a decision to increase or decrease its inventory. Planned inventory changes represent increases or decreases in inventory that have been decided by a firm. For example, an increase in planned inventory levels increases investment demand. Unplanned inventory changes occur unexpectedly and have an inverse effect on the investment demand curve. When inventory levels increase unexpectedly firms decrease their investment and vice versa. 31. 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. 32. Which is the most volatile component of total spending? What four factors contribute to the volatility of this component of total spending? The most volatile component of aggregate spending is investment. In fact, investment generates most of the fluctuation in employment and output that takes place over the course of a business cycle. The four factors that contribute to its volatility are the durability of capital goods, the irregularity of technological

Basic Macroeconomic Relationships progress that generates innovation, and variability in both profits and expectations. 33. Compare the determinants of consumption with investment. Most economists regard investment as being less stable than consumption. Looking at the determinants of each factor, support this contention. The nonincome determinants of the consumption schedule are consumer wealth, expectations, real interest rates, household borrowing, and taxation. The determinants of investment are 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 schedule is more unstable than the consumption schedule. 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 nonincome factors include wealth, expectations, real interest rates, household borrowing, and taxation. Aside from a drastic change in government tax or transfer policies, the consumption schedule 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-canceling across the population. The two basic factors determining the level of investment spending are the expected rate of 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. 34. (Consider This) Why did the lowering of real interest rates during the Great Recession not boost investment spending? Given an investment demand curve that is linear and downsloping, a drop in real interest rates should have increased the quantity demanded for investment. That inverse relationship, however, between real interest rates and the quantity of investment demanded assumes that other factors do not change. During the Great Recession of 2007 2009, other factors such as a decline in expected returns from investment shifted the investment demand curve downward, thus offsetting the increase in the quantity of investment demanded from a lower real interest rate. 35. Whenever there is change in spending real GDP will change by a multiple of the initial change in spending. Explain this multiplier effect. The economy is characterized by repetitive, continuous flows of expenditures and income through which dollars spent by one group are received as income by another group. Any change in spending will cause a chain reaction where a group whose income changes because of the spending change will in turn have a new level of spending which reflects their new level of income. When their spending increases or decreases, another group will find its income affected. Their spending will change by a fraction of that amount and so on. The end result of the initial change in spending will be several rounds of changes in

Chapter 24 income and spending so that the final impact on the economy s GDP is a multiple of the original change in spending. 36. 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. 37. 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. 38. Explain the economic impact of an increase in the multiplier. The multiplier magnifies the fluctuations in economic activity initiated by changes in investment spending, net exports, government spending, or consumption spending. The larger the multiplier the greater will be the impact of any changes in spending on real GDP. 39. Consider the effect of the following on the multiplier. (a) As a recession ends and recovery begins consumers are feeling less cautious about spending. (b) As the economy moves into an expansion, spending increases. (c) Uncertainty about national security and political relations abroad causes the public to adjust by saving more to use in case of an economic downturn worldwide. (a) Given that consumers are feeling less cautious about spending, the marginal propensity to consume will likely increase. Looking at the relationship between the multiplier and marginal propensity to consume, we can see that as MPC rises, the multiplier will rise. (b) This situation does not necessarily translate into an increase in the marginal propensity to consume. Incomes may have simply risen, while the MPC remained constant and spending could have risen. So, in this case there is likely no change in the multiplier. (c) The increase in saving due to national and political uncertainty will cause the marginal propensity to save to increase. Given the relationship between the multiplier and MPS, the increase in MPS will cause the multiplier to decline. 40. What is the relationship between the multiplier and the marginal propensities? The multiplier is directly related to the marginal propensities. 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).

Basic Macroeconomic Relationships 41. 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). 42. Calculate the multiplier when the MPC is.5,.75,.90. What is the relationship between MPC and the multiplier? When MPC =.5, the multiplier is 2. When MPC =.75, the multiplier is 4. When MPC =.90, the multiplier is 10. The relationship between MPC and the multiplier is direct. As the MPC increases, so does the multiplier [multiplier = 1/MPC]. 43. Calculate the multiplier when the MPS is.5,.25,.10. What is the relationship between MPS and the multiplier? When MPS =.5, the multiplier is 2. When MPS =.25, the multiplier is 4. When MPS =.10, the multiplier is 10. The relationship between MPS and the multiplier is inverse. As the MPS decreases, so the multiplier increases [multiplier = 1/(1 MPS)]. 44. How large is the actual multiplier? The basic multiplier (1/MPS) in the text reflects only the leakage of income into saving. There can also be other leakages of income from taxes or imports. It is better to think of the denominator for the multiplier in more general terms as the fraction of the change in income which leaks or is diverted from the income stream. When all these leakages saving, taxes, and import spending are added to the denominator of the multiplier, they reduce the size of the multiplier effect. The Council of Economic Advisor has estimated that the actual multiplier for the United States is about 2. 45. Describe the events Squaring the Economic Circle and explain how they illustrate the multiplier. Humorist Art Buchwald illustrates the multiplier with this funny essay that shows how the effect of one economic event on one party has an effect on a second party. These effects on the second party, in turn, have an effect on a third party, and so forth, creating a ripple throughout the economy. These related and multiple effects serve to illustrate the multiplier. Hofberger, a Chevy salesman in Tomcat, VA, called up Littleton of Littleton Menswear & Haberdashery, and told him that a new Nova had been set aside for Littleton and his wife. Littleton said he was sorry, but he couldn t buy a car because he and Mrs. Littleton were getting a divorce. Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the Hofbergers home. Hofberger said he couldn t, because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger could not afford to paint his house. When Bedcheck went home that evening, he told his wife to return their new television set to Gladstone s TV store. When she returned it the next day, Gladstone immediately called his travel agent and canceled his trip. He said he couldn t go because Bedcheck returned the TV set because Hofberger didn t sell a car to Littleton because Littletons are divorcing. Sandstorm, the travel agent, tore up Gladstone s plane tickets, and immediately called his banker, Gripsholm, to tell him that he couldn t pay back his loan that month. When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the banker told him that he had no money to lend because Sandstorm had not repaid his loan yet. Rudemaker called his contractor, Eagleton, who had to lay off eight men. General Motors announced it would give a rebate on its new models. Hofberger called Littleton to tell him that he could probably afford a car even with the divorce. Littleton said that he and his wife had made up and were not divorcing. His business, however, was so lousy that he couldn t afford a car now. His regular customers, Bedcheck,

Gladstone, Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month. Chapter 24