Check Your Understanding

1. Question

   Explain why a decline in investment spending caused by a change in business expectations leads to a fall in consumer spending.

   A decline in investment spending has a multiplier effect on real GDP. The fall in actual investment spending, I, leads to an initial fall in real GDP, which leads to a fall in disposable income (because less production means a decrease in payments to workers), which leads to lower consumer spending, which leads to another fall in real GDP, and so on. Thus, consumer spending falls as an indirect result of the fall in investment spending.

2. Question

   What is the spending multiplier if the marginal ropensity to consume is 0.5? What is it if MPC is 0.8?

   When MPC is 0.5, the spending multiplier is equal to 1/(1 - 0.5) = 1/0.5 = 2. When MPC is 0.8, the spending multiplier is equal to 1/(1 - 0.8) = 1/0.2 = 5.

3. Question

   Suppose a crisis in the capital markets makes consumers unable to borrow and unable to save money. What implication does this have for the effects of expected future disposable income on consumer spending?

   If you expect your future disposable income to fall, you would like to save some of today’s disposable income to tide you over in the future. But you cannot do this if you cannot save. If you expect your future disposable income to rise, you would like to spend some of tomorrow’s higher income today. But you cannot do this if you cannot borrow. If you cannot save or borrow, your expected future disposable income will have no effect on your consumer spending today. In fact, your MPC must always equal 1: you must consume all your current disposable income today, and you will be unable to smooth your consumption over time.

4. Question

   For each event, explain whether the initial effect is a change in planned investment spending or a change in unplanned inventory investment, and indicate the direction of the change.

   1. an unexpected increase in consumer spending

      An unexpected increase in consumer spending will result in a reduction in inventories as producers sell items from their inventories to satisfy this short-term increase in demand. This is negative unplanned inventory investment: it reduces the value of producers’ inventories.

   2. a sharp rise in the interest rate

      A rise in the interest rate means that fewer investment spending projects are now profitable to producers, whether they are financed through borrowing or retained earnings. As a result, producers will reduce the amount of planned investment spending.

   3. a sharp increase in the economy’s growth rate of real GDP

      A sharp increase in the rate of real GDP growth leads to a higher level of planned investment spending by producers as they increase production capacity to meet higher demand.

   4. an unanticipated fall in sales

      As sales fall, producers sell less, and their inventories grow. This leads to positive unplanned inventory investment.