QUESTIONS: BASIC MACROECONOMIC RELATIONSHIPS

8-1 Very briefly summarize the relationships shown by (a) the consumption
schedule, (b) the saving schedule, (c) the investment demand curve, and (d) the
multiplier effect. Which of these relationships are direct (positive) relationships
and which are inverse (negative) relationships?
8-2 Precisely how do the APC and the MPC differ? Why must the sum of the MPC
and the MPS equal 1? What are the basic determinants of the consumption and
saving schedules? Of your personal level of consumption?

8-3 Explain how each of the following will affect the consumption and saving
schedules (as they relate to GDP) or the investment schedule:
a. A large increase in the value of real estate, including private houses.
b. A decline in the real interest rate.
c. A sharp, sustained decline in stock prices.
d. An increase in the rate of population growth.
e. The development of a cheaper method of manufacturing computer chips.
f. A sizable increase in the retirement age for collecting Social Security benefits.
g. An increase in the Federal personal income tax.
8-4 Explain why an upward shift in the consumption schedule typically involves an
equal downshift in the saving schedule. What is the exception to this
relationship?

8-5 (Key Question) Complete the accompanying table.

Level of Output
and income
(GDP = DI) Consumptio Saving APC APS MPC MPS
n
P240 P _____ P-4 _____ _____ _____ _____
260 P _____ 0 _____ _____ _____ _____
280 _____ 4 _____ _____ _____ _____
300 _____ 8 _____ _____ _____ _____
320 _____ 12 _____ _____ _____ _____
340 _____ 16 _____ _____ _____ _____
360 _____ 20 _____ _____ _____ _____
380 _____ 24 _____ _____ _____ _____
400 _____ 28 _____ _____ _____ _____

Data for completing the table (top to bottom). Consumption: P244; 260; 276; 292; 308;
324; 340; 356; 372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .
00; .01; .03; .04; .05; .06; .06; .07. MPC: .80 throughout. MPS: .20 throughout.
a. Show the consumption and saving schedules graphically.
b. Find the break-even level of income. Explain how is it possible for
households to dissave at very low income levels.
c. If the proportion of total income consumed (APC) decreases and the
proportion saved (APS) increases as income rises, explain both verbally and
graphically how the MPC and MPS can be constant at various levels of
income.

8-6 What are the basic determinants of investment? Explain the relationship
between the real interest rate and the level of investment. Why is investment
spending unstable? How is it possible for investment spending to increase even
in a period in which the real interest rate rises?

8-7 (Key Question) Suppose a handbill publisher can buy a new duplicating machine
for P500 and the duplicator has a 1-year life. The machine is expected to
contribute P550 to the year’s net revenue. What is the expected rate of return?
If the real interest rate at which funds can be borrowed to purchase the machine
is 8 percent, will the publisher choose to invest in the machine? Explain.

8-8 (Key Question) Assume there are no investment projects in the economy which
yield an expected rate of return of 25 percent or more. But suppose there are
P10 billion of investment projects yielding expected rate of return of between 20
and 25 percent; another P10 billion yielding between 15 and 20 percent; another
P10 billion between 10 and 15 percent; and so forth. Cumulate these data and
present them graphically, putting the expected rate of net return on the vertical
axis and the amount of investment on the horizontal axis. What will be the
 equilibrium level of aggregate investment if the real interest rate is (a) 15
percent, (b) 10 percent, and (c) 5 percent? Explain why this curve is the
investment-demand curve.

8-9 (Key Question) What is the multiplier effect? What relationship does the MPC
bear to the size of the multiplier? The MPS? What will the multiplier be when
the MPS is 0, .4, .6, and 1? What will it be when the MPC is 1, .9, .67, .5, and 0?
How much of a change in GDP will result if firms increase their level of
investment by P8 billion and the MPC is .80? If the MPC is .67?

8-10 Why might the actual multiplier be less than the theoretical multiplier?

8-12 Advanced analysis: Suppose that the linear equation for consumption in a
hypothetical economy is C = 40 + .8Y. Also suppose that income (Y) is P400.
Determine (a) the marginal propensity to consume, (b) the marginal propensity
to save, (c) the level of consumption, (d) the average propensity to consume, (e)
the level of saving, and (f) the average propensity to save.

ANSWERS
8-1
(a) The consumption schedule or curve shows how much households plan to consume at
various levels of disposable income at a specific point in time, assuming there is no
change in the nonincome determinants of consumption. A change in disposable
income causes movement along a given consumption curve. A change in a
nonincome determinant causes the entire schedule or curve to shift.
(b) The saving schedule or curve shows how much households plan to save at various
levels of disposable income at a specific point in time, assuming there is no change in
the nonincome determinants of saving.
(c) The investment demand curve shows how much will be invested at all possible
interest rates, given the expected rate of net profit from the proposed investments,
assuming there is no change in the noninterest-rate determinants of investment.
(d) The multiplier effect shows how an initial change in spending can flow through the
system to generate a larger change in GDP.
Consumption and saving are directly (positively) related to income. Investment is
inversely (negatively) related to the real interest rate. The multiplier directly relates
changes in spending to changes in GDP.

8-2 APC is an average whereby total spending on consumption (C) is compared to total
income (Y): APC = C/Y. MPC refers to changes in spending and income at the margin.
Here we compare a change in consumer spending to a change in income: MPC = change
in C / change in Y.
When your income changes there are only two possible options regarding what to do with
it: You either spend it or you save it. MPC is the fraction of the change in income spent;
therefore, the fraction not spent must be saved and this is the MPS.
 The basic determinants of the consumption and saving schedules are the levels of income
and output.
8-3
(a) If this simply means households have become more wealthy, then consumption will
increase at each income level. The consumption schedule should shift upward and the
saving schedule shift downward. The investment schedule may shift rightward if
owners of existing homes sell them and invest in construction of new homes more
than previously.
(b) The decline in the real interest rate will increase interest-sensitive consumer
spending; the consumption schedule will shift up and the saving schedule down.
Investors will increase investment as they move down the investment-demand curve;
the investment schedule will shift upward.
(c) A sharp decline in stock prices can be expected to decrease consumer spending
because of the decrease in wealth; the consumption schedule shifts down and the
saving schedule upwards. Because of the depressed share prices and the number of
speculators forced out of the market, it will be harder to float new issues on the stock
market. Therefore, the investment schedule will shift downward.
(d) The increase in the rate of population growth will, over time, increase the rate of
income growth. In itself this will not shift any of the schedules but will lead to
movement upward to the right along the upward sloping investment schedule.
(e) This innovation will in itself shift the investment schedule upward. Also, as the
innovation starts to lower the costs of producing everything using these chips, prices
will decrease leading to increased quantities demanded. This, again, could shift the
investment schedule upward.
(f) The postponement of benefits may cause households to save more if they planned to
retire before they qualify for benefits; the saving schedule will shift upward, the
consumption schedule downward. This impact is uncertain, however, if people
continue to work and earn productive incomes.
(g) Because this reduces disposable income, consumption will decline in proportion to
the marginal propensity to consume. Consumption will be less at each level of real
output, and so the curve shifts down. The saving schedule will also fall because the
disposable income has decreased at each level of output, so less would be saved.
8-4 If, by definition, all that you can do with your income is use it for consumption or saving,
then if you consume more out of any given income, you will necessarily save less. And
if you consume less, you will save more. This being so, when your consumption
schedule shifts upward (meaning you are consuming more out of any given income), your
saving schedule shifts downward (meaning you are consuming less out of the same given
income).
The exception is a change in personal taxes. When these change, your disposable income
changes, and, therefore, your consumption and saving both change in the same direction
and opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1.
Now, if your taxes increase by P100, your consumption will decrease by P90 and your
saving will decrease by P10.
8-5 See the graphs.
 (b) Break-even income = P260. Households dissave borrowing or using past savings.
(c) Technically, the APC diminishes and the APS increases because the consumption
and saving schedules have positive and negative vertical intercepts respectively.
(Appendix to Chapter 1). MPC and MPS measure changes in consumption and
saving as income changes; they are the slopes of the consumption and saving
schedules. For straight-line consumption and saving schedules, these slopes do not
change as the level of income changes; the slopes and thus the MPC and MPS remain
constant.
8-6 The basic determinants of investment are the expected rate of return (net profit) that
businesses hope to realize from investment spending, and the real rate of interest.
When the real interest rate rises, investment decreases; and when the real interest rate
drops, investment increases—other things equal in both cases. The reason for this
relationship is that it makes sense to borrow money at, say, 10 percent, if the expected
rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed
money. But if the expected rate of net profit is less than 10 percent, borrowing the
money would be expected to result in a negative rate of return on the borrowed money.
Even if the firm has money of its own to invest, the principle still holds: The firm would
not be maximizing profit if it used its own money to carry out an investment returning,
say, 9 percent when it could lend the money at an interest rate of 10 percent.
Investment is unstable because, unlike most consumption, it can be put off. In good
times, with demand strong and rising, businesses will bring in more machines and replace
old ones. In times of economic downturn, no new machines will be ordered. A firm can
continue for years with, say, a tenth of the investment it was carrying out in the boom.
Very few families could cut their consumption so drastically.
New business ideas and the innovations that spring from them do not come at a constant
rate. This is another reason for the irregularity of investment. Profits and the
expectations of profits also vary. Since profits, in the absence of easy access to borrowed
money, are essential for investment and since, moreover, the object of investment is to
make a profit, investment, too, must vary.
As long as expected rates of return rise faster than real interest rates, investment spending
may increase. This is most likely to occur during periods of economic expansion.
8-7 The expected rate of return is 10% (P50 expected profit/P500 cost of machine). The P50
expected profit comes from the net revenue of P550 less the P500 cost of the machine.
If the real interest rate is 8%, the publisher will invest in the machine as the expected
profit (marginal benefit) from the investment exceeds the cost of borrowing the funds
(marginal cost).
8-8 See the graph below. Aggregate investment: (a) P20 billion; (b) P30 billion; (c) P40 billion.
This is the investment-demand curve because we have applied the rule of undertaking all
investment up to the point where the expected rate of return, r, equals the interest rate, i.

8-9 The multiplier effect describes how an initial change in spending ripples through the
economy to generate a larger change in real GDP. It occurs because of the
interconnectedness of the economy, where a change in Lasslett’s spending will generate
more income for Gavidia, who will in turn spend more, generating additional income for
Grimes.
The MPC is directly (positively) related to the size of the multiplier. The MPS is
inversely (negatively) related to the size of the multiplier.
The multiplier values for the MPS values: undefined, 2.5, 1.67, 0.
The multiplier values for the MPC values: undefined, 10, 3 (approx. actually 3.03), 2, 0.
If MPC is .80, change in GDP is P40 billion (5 x P8 = P40)
If MPC is .67, change in GDP is P24 billion (approximately) (3 x P8 = P24)

8-10 The actual multiplier is smaller because it includes other leakages from the spending
and income cycle besides just saving. Imports and taxes reduce the flow of money back
into spending on domestically produced output, reducing the multiplier effect.
8-12
(a) MPC is .8
(b) MPS is 1  8  .2
(c) C  40  .8 P 400  40  P320  P360
(d) APC  P360 / P 400  .9
(e) S  Y  C  P 400  P360  P 40
(f) APS  P 40 / P 400  .1 or 1  APC