ECON101 Module 8 (Exam 3) Exam Study Guide.

ECON101 Module 8 (Exam 3) Exam Study Guide. Introduction to aggregate expenditures - answerThe aggregate expenditures model proposes that total spending (aggregate expenditures) in an economy will, in equilibrium, be equal to total output. In this model, aggregate expenditures are classified into four different categories, which are identified by who is buying the output: consumption by households, investment by firms, government purchases, and net exports. If any of these types of spending increase, aggregate expenditures will also increase; firms will have to produce more output to meet the additional demand. Thus, an increase in aggregate expenditures will lead to an increase in real GDP. marginal propensities to consume and save - answerPART B: In which country would an increase in income lead to the largest change in consumption? Solution: The country that would have the largest change in consumption is the country that has the largest MPC. PART C: In which country would an increase in income lead to the largest change in savings? Solution: The country that would have the largest change in savings as a result of a change in income is the country with the largest MPS. Since MPC + MPS = 1, the country with the highest MPS must also have the lowest MPC. After you've paid your taxes, you can do two things with an additional dollar of disposable income: spend it or save it. The fraction of each additional dollar that you choose to spend is called the marginal propensity to consume (MPC). The fraction that you save is called the marginal propensity to save (MPS). Because you must either spend the dollar or save it, MPC + MPS = 1. To determine the value of the MPC for an economy, we can observe a given increase in income (∆Y), see how much of it is spent on consumption (∆C), and then calculate MPC = ∆C/∆Y. consumption and income - answerAutonomous consumption is equal to consumption expenditure when income equals zero. That consumption is funded by drawing on savings or by borrowing. Notice that the marginal propensity to consume (MPC) can be found by taking the change in C and dividing by the change in Y (real GDP): thus, the slope of the consumption function is also the MPC. PART C: Draw the equilibrium line representing the combinations of consumption and real GDP that are equal to each other. Solution: A line through the origin with a slope of 1 (or 45 degrees, depending on whether you prefer to express lines in slopes or degrees) would show all the combinations of consumption and real GDP that are equal. Note that at any point on this line, the length of a line from the point straight down to the x axis (which would be the amount of consumption) is equal to the length of the line from the point straight across to the y axis (which is the amount of real GDP). What happens to consumption when a person's income increases? As income increases, most people consume a fraction of the additional income and save the rest. Thus, there is a positive relationship between income and consumption. If we graph this relationship, we create a consumption schedule —the first piece in our aggregate expenditures model. The slope of the consumption schedule is equal to the marginal propensity to consume (MPC). The larger the MPC, the steeper the consumption schedule. Equilibrium in the aggregate expenditures model occurs when aggregate expenditures are equal to output. We can express this concept with an equilibrium line (or 45-degree line): the line that shows all possible equilibriums in the economy, points at which aggregate expenditure is equal to output. Equilibrium consumption occurs where the consumption schedule intersects with the equilibrium line. savings and income - answerPART A: Use the fact that the marginal propensity to consume in Zamunda is 0.8 to complete the table. Solution: Since every dollar of disposable income must be either spent or saved, if the marginal propensity to consume is 0.8, then the marginal propensity to save must be 0.2. Thus, every time income increases by $1,000, consumption increases by $800 and savings increases by $200. As income increases, most people will consume a fraction of the additional income and will save the rest. If we graph the relationship between income and savings, we create a savings schedule that shows how much is saved at different levels of income. In a simple aggregate expenditures model, the only component of spending is consumption; at equilibrium in that model, consumption is equal to real GDP. Thus, savings equals zero since all income is consumed. Savings becomes positive for the economy as a whole once we add other sectors (investment, government spending, and net exports) to make the model better reflect the real world.