04/05/2007

Hakan TASCI

Econ 201: Principles of Economics

1.

What we have done so far?

Economic aggregates are not observable in the real world.
Aggregation involves adding together different products and services.
If aggregate demand keeps shifting rightward month after month and aggregate supply
remains constant, the economy will experience a recession.
GDP in 2001 would not include the resale of a house built in 1978.
Illegal gambling on the NCAA Final Four would be included in GDP
Gross Domestic Product accurately measures the environmental costs of producing all
goods and services.
Changes in nominal GDP always reflect changes in real output
Technological change and labor productivity are negatively related.
India has a much larger GDP than Switzerland. Therefore, the citizens of India are richer
than the citizens of Switzerland.
Frictional unemployment will typically be a short-term problem for someone between
jobs.
Cyclical unemployment occurs when real GDP falls below potential GDP.

2. Todays Outline
Calculating GDP: Expenditure Approach
Consumption and Marginal Propensity to Consume
Factors that Shift Consumption Function
Investment and Government Spending
Net Exports and Its Determinants
3. Calculating GDP: Expenditure Approach
Aggregate Demand (AD): The total amount that all consumers, business firms, and
government agencies are willing to spend on final goods and services
Consumer Expenditure (C) : is the total amount spent by consumers on newly produced
goods and services. (excluding home which is an investment good). It is around 2/3 of
aggregate demand.
Investment Spending (I): is the amount spent by firms on factories, machinery, software
plus home expenditure of households. Financial investments (stocks, bank deposits) are
not included nor are resale of existing physical assets.
Government Purchases (G): refer to the goods and services purchased by government.
(Schools, teaching, police, health departments)
Net Exports (NX): Exports- Imports, is the difference between exports and imports of a
country.
National Income (Y): is the sum of the incomes that all individuals in the economy
earned in the forms of wages, rents, interest, profits. It excludes government transfer
payments and taxes are not deducted from it.
So final remark in order to have equilibrium in market:
Aggregate Demand = C + I + G + NX

National Demand = Aggregate Demand (Total Expenditure)

Transfer Payments: are the sums of money that the government gives certain
individuals as outright grants. Social security, unemployment benefits
Disposable income (DI): is the income that can be spent by consumers.
DI= GDP-Taxes+ Transfer payments
DI= Y-T

4. Consumption and Marginal Propensity to Consume

Consumption Function: shows the relationship between total consumer expenditures
and total disposable income in the economy.

Marginal Propensity to Consume (b): is the ratio of changes in consumption relative to

changes in disposable income.
Autonomous Consumption (a): is the consumption that individuals have to spend in
order to survive no matter what they earn. (Food spending, rent etc)
C = a + b. DI = a+ b.(Y-T)

5. Factors that Shift Consumption

Any change in disposable income moves us along a given consumption function
Determinants of shift:
Consumer Wealth: Wealth is not an income. Wealth is an accumulated sum of
physical and financial assets. If it increases than C shift upwards.
Price Level: Higher prices decrease demand for goods and services and C will
shift downwards.
Real Interest Rate: A higher interest rate raises the rewards of saving. People
tend to save more and spend less. C shift downwards. But in actual world the
relationship is just the opposite why?
Future Income Expectations: If you think you will earn in the future, then you
will spend more money. C shift outwards.

So we can conclude that real interest rate does not have a big influence on consumption
and so is the inflation.
Consumer Wealth:
Increase:

Decrease:

Price:
Increase:

Decrease:

Real Interest:
Increase:

Decrease:

Future Income Expectations
Increase:

Decrease:

6. Investment and Government Spending

Investment is the most volatile part of aggregate demand. Factors affecting Investment:
Real interest rate: If there is higher interest rate in market than investment will be
lower.
Technological progress and innovations will trigger investment to earn more by
using these new innovations.
Business confidence and expectations about the future. Measuring this is too hard
but the effect can be seen in the market.
Government spending level is a choice of government and it is assumed to be constant
right now. It does not depend on interest rate or income level or inflation.
7. Net Exports
This is another high variable source of aggregate demand. The determinants of net export
are:
National Income: Higher home country income triggers the import of home
country; hence net export will be higher. Imports are sensitive to home GDP but
not in foreign GDP generally. Exports are vice versa.
Relative Prices: Rise in a price of home country good, then exports decreases and
so is the net exports and vice versa
8. GDP Calculation: Other Methods
GDP as sum of incomes (or factor payments)
GDP as the sum of all factor payments
Value of factors outputs = value of incomes
GDP = wages + interest + rents + profits + purchases from other firms

GDP as the sum of values added

GDP = sum of values added
to goods in all firms
Value added = firms
revenue from selling a
product minus the amount
paid for goods and services
purchased from other firms

9. Multiple Choice Questions:

1.

If a U.S. citizen buys a car produced in Germany, this transaction will add to
a. U.S. aggregate demand.
b. U.S. aggregate supply.
c. German aggregate demand.
d. German imports.

2.

Aggregate demand is the sum of

a. C + I + G + (X - IM).
b. C + I + X.
c. C + I + X IM.
d. C + I + G.

3.

National income is
a. the sum of all wages and salaries, interest, rent, and profits in the economy.
b. equal to the money value of national output.
c. the before-tax income of all individuals in the economy.
d. All of the above are correct.

4.

The difference between national income and disposable income is

a. residential investment.
b. federal deficits.
c. net exports.
d. financial investment.
e. the amount of taxes collected.

5.

The largest component of aggregate demand is

a. investment spending.
b. consumer spending.
c. government spending.
d. total imports.

6.

Disposable income can be defined as national product

a. minus federal and state taxes.
b. minus taxes plus transfers.
c. minus indirect taxes.
d. plus taxes plus transfers.

7.

Which of the following is a transfer payment?

a. Work-study students receive wages transferred from the university budget.
b. A company pays the moving expenses for a transferred employee.
c. A student transfers to another college and receives a tuition rebate.
d. A student receives a tuition grant from the federal government.

8.

On a graph with consumption on the vertical axis and disposable income on the horizontal
axis, the slope of the line is
a. greater than one.
b. equal to one.
c. less than one.
d. undefined.

9.

If personal taxes are increased by $10 billion, we can expect that consumers will reduce
a. spending by $10 billion.
b. spending by more than $10 billion.
c. spending by less than $10 billion.
d. saving by $10 billion.
e. saving by more than $10 billion.

10.

The nations disposable income increases by $400 billion and, as a result, consumer
spending increases by $320 billion. Therefore, the MPC equals
a. 16.
b. 20.
c. 60.
d. 80.
e. 96.

11.

The marginal propensity to consume (MPC) is calculated by which formula?

a. MPC = change in DI divided by change in C
b. MPC = change in GDP divided by change in DI
c. MPC = change in C divided by change in DI
d. MPC = change in C divided by change in GDP

12.

A decrease in disposable income will

a. lead to an upward movement along the consumption function.
b. lead to a downward movement along the consumption function.
c. shift the consumption function upward.
d. shift the consumption function downward.

13.

Which of the following is an example of wealth?

a. a yearly salary of $40,000
b. a mutual fund balance of $1,000
c. rental payments of $3,000 per month
d. stock dividends of $500 per quarter

14. After years of hard work in the field of macroeconomics, you win the Nobel Prize in
economics (currently $1 million). What is the most likely effect of this prize on your consumption
function?
a. It will shift downward temporarily.
b. It will shift upward temporarily.
c. It will shift downward permanently.
d. It will shift upward permanently.
15.

Suppose the federal government wants to encourage businesses to increase investment

spending. Which policy may be the most effective?
a. an increase in corporate income taxes
b. an increase in real interest rates
c. an increase in warnings of a coming recession
d. an increase in tax deductions for investment spending

16.

U.S. imports are most likely to increase when

a. U.S. GDP decreases.
b. U.S. unemployment rates fall.
c. U.S. prices fall.
d. foreign prices rise.