Economics

Simple Spending Multiplier Suppose that the MPC is 0.8, while investment, government purchases, and net exports sum to $500 billion. Suppose also that the government budget is in balance. a. What is the sum of saving and net taxes when desired spending equals real GDP? Explain. b. What is the value of the multiplier? c. Explain why the multiplier is related to the slope of the consumption function.

REAL GDP DEMANDED In your own words, explain the logic of the income-expenditure model. What determines the amount of real GDP demanded?

Suppose that C = 100 + 0.75( Y - 100), I = 50, G = 30, and X - M = -100, all in billions of dollars. What is the simple spending multiplier? What is real GDP demanded? What would happen to real GDP demanded if government purchases increased to $40 billion?

Case Study: The Ripple Effect of 9/11 How do events, such as the World Trade Center and Pentagon attacks described in the case study "The Ripple Effects of 9/11" affect the aggregate expenditure line and the aggregate demand curve? Explain fully. Reference Case study: Public Policy The Ripple Effect on the Economy of 9/11 When hijacked planes hit the World Trade Center and the Pentagon, America's sense of domestic security changed. The thousands of lives lost and the billions of dollars of property destroyed were chronicled at length in the media. Let's look at the impact of the tragedy on just one industry-air travel-to see how slumping demand there affected aggregate expenditure. Once aviation regulators became aware of the hijackings, they grounded all nonmilitary aircraft immediately. This cost the airlines hundreds of millions of dollars a day in lost business. During the days following the attack, video of the second plane crashing into the twin towers was shown again and again, freezing this image in people's minds and heightening public concerns about airline safety. These worries, coupled with the airport delays from added security (passengers were told to arrive up to three hours before flights), reduced the demand for air travel once planes were allowed to fly again. For short flights, it became quicker and easier to drive than to fly. Two weeks after the attacks, airlines were operating only 75 percent of their flights, and these flights were only 30 percent full instead of the usual 75 percent full. Airlines requested federal support, saying they would go bankrupt otherwise. Congress quickly approved a $15 billion aid package of loans and grants. Despite the promise of federal aid, airlines laid off 85,000 workers, or about 20 percent of their workforce. Flight reductions meant that as many as 900 aircraft would be parked indefinitely, so investment in new planes collapsed. Boeing, the major supplier of new planes and America's leading exporter, announced layoffs of 30,000 workers. This triggered layoffs among suppliers of aircraft parts, such as jet engines and electronic components. For example, Rockwell Collins, an electronics supplier, said 15 percent of its workforce would lose jobs. Other suppliers in the airline service chain also cut jobs. Sky Chef, a major airline caterer, laid off 4,800 of its 16,000 employees. Airports began rethinking their investment plans. Half the major U.S. airports said they were reevaluating capital improvement plans to see if these investments made sense in this new environment. Honolulu airport, for example, suspended plans to add extra gates and renovate its overseas terminals. Within three weeks after the attacks, job cuts announced in the industry exceeded 150,000. These were part of only the first round of reduced consumption and investment. In an expanding economy, job losses in one sector can be made up by job expansions in other sectors. But the U.S. economy was already in a recession at the time of the attack, having lost about a million jobs between March 2001 and September 2001. People who lost jobs or who feared for their jobs reduced their demand for housing, clothing, entertainment, restaurant meals, and other goods and services. For example, unemployed flight attendants would be less likely to buy new cars, reducing the income of autoworkers and suppliers. People who lost jobs in the auto industry would reduce their demand for goods and services. So the reductions in airline jobs had a ripple effect. Airlines are only one part of the travel industry. With fewer people traveling, fewer needed hotel rooms, rental cars, taxi rides, and restaurant meals. Each of those sectors generated a cascade of job losses. The terrorist attacks also shook consumer confidence, which in September 2001 suffered its largest monthly drop since October 1990, on the eve of the first Persian Gulf War. Within 10 days following the attacks, the number of people filing for unemployment benefits jumped to a nine-year high. Again, these early job losses could be viewed as just part of the first round of reduced aggregate expenditure. The second round would occur when people who lost jobs or who feared they would lose their jobs started spending less. The U.S. economy continued to shed jobs for nearly two years after the attacks, losing about 2 million more jobs. Researchers estimate that business interruptions resulting from the attacks cost the U.S. economy a little over $100 billion, or about 1 percent of GDP.

AGGREGATE EXPENDITURE What are the components of aggregate expenditure? In the model developed in this chapter, which components vary with changes in the level of income? What determines the slope of the aggregate expenditure line?

Shifts of Aggregate Demand Assume the simple spending multiplier equals 10. Determine the size and direction of any changes of the aggregate expenditure line, real GDP demanded, and the aggregate demand curve for each of the following changes in spending: a. Spending rises by $8 billion at each income level. b. Spending falls by $5 billion at each income level. c. Spending rises by $20 billion at each income level.

SIMPLE SPENDING MULTIPLIER For each of the following values for the MPC, determine the size of the simple spending multiplier and the total change in real GDP demanded following a $10 billion decrease in spending: a. MPC = 0.9 b. MPC = 0.75 c. MPC = 0.6

Net Exports and the Spending Multiplier Suppose that the marginal propensity to consume (MPC) is 0.8 and the marginal propensity to import (MPM) is 0.05. a. What is the value of the spending multiplier? b. By how much would the real GDP demanded change if investment increased by $100 billion? c. Using your answer to part (b), calculate the change in net exports caused by the change in aggregate output.

WHEN OUTPUT AND SPENDING DIFFER What role do inventories play in determining real GDP demanded? In answering this question, suppose initially that firms are either producing more than people plan to spend, or producing less than people plan to spend.

REAL GDP DEMANDED What equalities hold at the level of real GDP demanded? When determining real GDP demanded, what do we assume about the price level? What do we assume about inventories?

SIMPLE SPENDING MULTIPLIER Suppose that the MPC is 0.8 and that $14 trillion of real GDP is currently being demanded. The government wants to increase real GDP demanded to $15 trillion at the given price level. By how much would it have to increase government purchases to achieve this goal?

INVESTMENT AND THE MULTIPLIER This chapter assumes that investment is independent of the income level in the economy. What would happen to the size of the multiplier if investment increases as real GDP increases? Explain.

Simple Spending Multiplier "A rise in investment in an economy leads to a rise in spending." Use the spending multiplier to verify this statement.

THE AGGREGATE DEMAND CURVE What is the effect of a lower price level, other things constant, on the aggregate expenditure line and real GDP demanded?

Case Study: Bringing Theory to Life What are the components of consumption discussed in the case study? How did each component change in the recession of 2008-2009? Reference Case Study: Bringing Theory to Life? Consumer Spending on Services During the Recession As noted earlier, consumption is the largest component of aggregate spending, averaging about 70 percent of the total during the past decade. And consumption depends primarily on income. But at any given level of income, consumption depends on other factors, such as net wealth. The biggest source of net wealth for most households is their home. Nationally, home prices increased steadily between 1987 and 2006, tripling on average during a long march upward. The rise in housing prices made homeowners feel flush and thus more inclined to spend at each income level. Consumption as a share of disposable income rose from 90 percent in 1987 to 94 percent in 2006. But there is no economic law that says home prices can't fall. Let's look at what happened to consumption and real GDP when home prices turned down sharply. After peaking in 2006, average home prices in the United States dropped about 22 percent by the third quarter of 2008. That was the first sustained drop in at least two decades and it shook people up. In later chapters, we'll look at the wider fallout from the housing bust, but here the focus is on consumer spending. Percent changes in consumption, its components, and in real GDP are shown in Exhibit 6 for the four quarters in the heart of what some have called the Great Recession. Real GDP in the third quarter of 2008 fell 4.0 percent (at an annualized rate). Consumption fell 3.5 percent, the biggest drop since 1980. During the four quarters shown, the decline in GDP averaged 4.1 percent and the decline in consumption averaged 2.2 percent. As usual, consumption varied less than GDP. Let's sort consumption into its components. With the economy souring, with job prospects looking iffy, and with the stock market crashing, many households decided to put off buying new cars, new furniture, and other durable goods. Consumer spending on durable goods dropped 12.0 percent in the third quarter of 2008. That drop nearly doubled in the fourth quarter to 22.3 percent, the largest fall since 1981. For the four quarters, the decline averaged 8.2 percent. All this would be a big problem for the economy except for one fact: Durable goods account for a small share of all consumption, just 12 percent.