Solutions for End of Chapter Questions
Chapter 16
Easy
1 (a) Find equilibrium income when investment demand is 400 and C = 0.8Y. (b) Would output be
higher or lower if the consumption function were C = 100 + 0.7Y?
1 (a) Y = C + I
Y = £400 + 0.8Y
0.2Y= £400
Y = £2000
(b) Y =C + I
Y = £400 + £100 + 0.7Y
0.3Y = £500
= £1,667. Therefore, the output is lower
A-head: 16.3 Equilibrium output
Learning Objective: Show how aggregate demand determines short-run equilibrium output
Type: Calculation
2 Which of the following statements is correct? (a) Any tax is a tax on jobs because it reduces
aggregate demand. (b) Provided the government spends the tax revenue, the impact of higher
spending outweighs the adverse demand effect of higher taxes. (c) Autonomous consumption
demand is directly related to consumer confidence. (d) All the above statements could be true,
depending on the other things assumed equal.
2 (d) all the above statements could be true, depending on the other things assumed equal.
A-head: 16.5 A fall in aggregate demand
Learning Objective: Analyse consumption and investment demand
Type: Application
3 Suppose firms are initially surprised by changes in demand. (a) When demand falls, what is the
initial effect on stocks of unsold goods held by firms? (b) What do firms plan to do to stocks as
soon as they have time to adjust production? Does this reduce or increase the initial fall in
demand? (c) Once stocks have been adjusted, what then happens to production and output?
3 (a) There is an unplanned rise in stocks.
(b) Firms plan negative inventory investment to reduce stocks – this provides a second round
reduction in aggregate demand.
(c) Once stocks have been adjusted, there is no need to keep planning to reduce them, so
planned inventory investment increases (from a negative number to zero). This effect is one of
the causes of a subsequent rise in aggregate demand and hence a cyclical response to the initial
shock.
A-head: 16.5 A fall in aggregate demand
Learning Objective: Show how aggregate demand determines short-run equilibrium output
Type: Application
4 Could the multiplier ever be less than 1?
4 In the simple model used in this chapter, the multiplier 1/ s is always greater than +1, since 0 < s
< 1. However, the combined leakages other than savings may be sufficient to reduce the
multiplier below unity.
A-head: 16.6 The multiplier
Learning Objective: Calculate the multiplier
Type: Conceptual Understanding
5 Common fallacies Why are these statements wrong? (a) If people were prepared to save more,
investment would increase and we could get the economy moving again. (b) Lower output leads
to lower spending and yet lower output. The economy could spiral downwards for ever.
5 (a) This is the essence of the Keynesian revolution. Ultimately, in a closed economy I and S are
equal but it is the level of I which determines the level of saving, and not vice versa. Higher saving
reduces aggregate demand and so the level of economic activity would be further reduced rather
than “get moving again”.
(b) Because MPC < 1, each fall in output causes a smaller fall in demand, so the process
eventually comes to a halt.
A-head: 16.6 The multiplier, 16.7 The paradox of thrift
Learning Objective: Show how the marginal propensity to consume affects the multiplier, Explain
the paradox of thrift
Type: Conceptual Understanding
Medium
6 Assume that an economy is in equilibrium. Planned investment is £100. The MPC is 0.6. Suppose,
investment rises by £30. (a) What happens to the equilibrium output?
Now, suppose people decide to save a higher proportion of their income: the consumption
function changes from C = 0.8Y to C = 0.5Y. (b) What happens to equilibrium income (planned
investment being £100)? (c) What happens to the equilibrium proportion of income saved?
Explain.
6 (a) The multiplier is 2.5 (1/1-0.6), therefore the output increase by £30 x 2.5 = £75.
(b) When C = 0.8Y, the equilibrium level of output is: Y = 0.8Y + 100 or Y = £500. If C falls to 0.5 Y,
the equilibrium output changes to: Y = 0.5Y + 100 or Y = £200.
(c) In the absence of Government and export/import sectors, S = I. Savings therefore remains
unchanged at £100 but which is equal to 0.5Y.
A-head: 16.3 Equilibrium output
Learning Objective: Define short-run equilibrium output
Type: Calculation
7 Assume that the economy is in equilibrium. The MPC is 0.6. Suppose, investment demand rises by
£30. (a) By how much does the equilibrium output increase? (b) How much of that increase is
extra consumption demand? Draw the corresponding diagram using planned investment and
planned saving assuming that the initial output is 100.
7 (a) Aggregate demand is an upward sloping line, with positive height when output is zero, and a
slope of 0.6. The increase in investment leads to a parallel upward shift in the aggregate demand
curve by a vertical distance of 30. It now intersects the 45 degree line at an output level that is 75
units higher than before. Investment increases by 30 and planned consumption by 45.
(b) Investment is a horizontal line and the saving function slopes upward as output increases. A
vertical upward shift in 30 in investment now intersects the saving function at an output that is
75 units higher than the initial output. Again, if investment accounts for 30 of the total increase in
output, planned consumption must account for 45.
A-head: 16.4 Planned saving equals planned investment
Learning Objective: Define short-run equilibrium output
Type: Graphing
8 Suppose the consumption function is C = 0.75Y and planned investment is 40. (a) Draw a diagram
showing the aggregate demand schedule. (b) If actual output is 100, what unplanned actions will
occur? (c) What is the equilibrium output? (d) Do you get the same answer using planned saving
equals planned investment?
8 (a) Intercept = 40, slope = 0.75.
(b) Destocking
(c) The equilibrium output is 160.
(d) Yes: 40 = 0.25Y
Y = 40/0.25
Y = 160
A-head: 16.3 Equilibrium output, 16.4 Planned saving equals planned investment
Learning Objective: Define short-run equilibrium output
Type: Graphing
9 The diagram given below shows the aggregate demand and output of an economy. Along the 45
degree line Y, demand equals output. Is there an inflationary gap or a deflationary gap in the
economy?
9 There is a deflationary gap in the economy of £100 billion. The aggregate demand is insufficient
to allow an equilibrium output of £250 billion.
A-head: 16.5 A fall in aggregate demand
Learning Objective: Explain inflationary and deflationary gaps
Type: Application
10 Suppose confidence depends a little on the current level of output, and the model therefore
becomes:
I = aY + I*
C = A + cY = [A* +bY] + cY, where I* and A* remain autonomous and independent of output, but
a and b reflect the dependence of confidence on the current level of output. (a) What is the new
value of the multiplier? (b) Is this higher or lower than before? (c) Is equilibrium output higher or
lower than before?
10 (a) Equilibrium output is now Y = [I*+A*] / [1 – c –a –b] and the multiplier is positive only if
(a+b+c) <1. If confidence depends ‘too much’ on current output, the economy is explosive– a gain
in output boosts confidence and demand, leading to further output and confidence gains that
keep going indefinitely. The multiplier is 1 / [1 – c –a –b].
(b)The new multiplier is higher than before.
(c)Whether equilibrium output is higher or not depends on how I* and A* compare with the
previous autonomous values of I and A. If they are the same, the additional confidence effect on
output implies that equilibrium output is higher because of the larger multiplier.
A-head: 16.6 The multiplier
Learning Objective: Calculate the multiplier
Type: Conceptual Understanding
11 When could the paradox of thrift fail to be true?
11 The paradox of thrift relies on output and income adjusting to restore desired injections and
desired leakages. In the model explained in this chapter, that can always happen. Once we
reintroduce aggregate supply, and in particular, a maximum capacity for the entire economy, it is
possible that there is an output ceiling above which output and income cannot go. The paradox
of thrift might then be frustrated.
A-head: 16.6 The paradox of thrift
Learning Objective: Explain the paradox of thrift
Type: Conceptual Understanding
Hard
12 Essay question ‘The remarkably strong relationship between consumption and income confirms
that most people want to spend most of their income as soon as they can. We are all material
girls and boys at heart.’ Is the inference justified?
12 This certainly seems to be the trend in most economies.
Recent events in Britain have highlighted the fall in the savings ratio and the accumulation of
household debt arising mainly from mortgages, unsecured loans and credit card liabilities. The
“boom years” 1997 – 2007 allowed households benefitting from increased incomes to indulge in
instant gratification without, apparently, any thought for the morrow.
However economists have devised other theories to help explain consumption patterns, all of
which could be examined and discussed.
 Wealth effects [when spending exceeds disposable income net wealth falls] and changes in
consumer credit are responsible for most of the shifts in the consumption function.
Financing dissaving involves selling off assets and/or borrowing money.

Money and interest rates alter consumer spending by affecting the quantity of consumer
credit and interest rates charged on it.
There are other theories which examine the relationship between consumption and income.
The permanent income hypothesis developed by Milton Friedman argues that consumption
depends on permanent income, not on current or disposable income.
The life cycle hypothesis, attributed to Franco Modigliani Albert, assumes people make a lifetime
consumption plan that is affordable out of lifetime income.
A-head: 16.1 Components of aggregate demand
Learning Objective: Analyse consumption and investment demand
Type: Conceptual Understanding
13 Planned investment is 100. Initially, the consumption function is C = 100 + 0.8Y. There are three
ways in which greater pessimism about the future might affect behaviour: (a) Planned
investment falls from 100 to 50 (b) autonomous consumption falls from 100 to 50. (c) The
marginal propensity to consume falls from 0.8 to 0.7 as people save more of each unit of
additional income. Draw a graph of each change and its effect on short-run equilibrium output.
13
Initially, the aggregate demand curve slopes up, with a positive slope of 0.8 and beginning from
200 when output is zero. It crosses the 45 degree line at an income of 1000.
(a) and( b) In either case there is a parallel downward shift in aggregate demand schedule by a
vertical distance of 50 and it now intersects the 45 degree line at an income of 750.
(c) Compared with the original situation, the aggregate demand schedule rotates, with a flatter
slope of 0.7 but the same height at the point at which output is zero. It now intersects the 45
degree line at an income of 667. Note that a small change in the marginal propensity to consume
can have a large effect on the multiplier and on equilibrium output/income.
A-head: 16.3 Equilibrium output
Learning Objective: How aggregate demand determines short-run equilibrium output
Type: Graphing
14 Suppose your economy is going through a recession phase. Individuals desire to save more and
spend less. How does the paradox of thrift explain the consequences of increased savings in your
economy?
14 The paradox of thrift suggests that a change in the amount households wish to save at each
income leads to a change in equilibrium income, but no change in equilibrium saving, which must
still equal planned investment.
If individuals try to save more during recession, the level of consumption in the economy
decreases, which reduces aggregate demand and thus reduces the total savings in the economy.
In equilibrium, planned saving always equals planned investment, and the latter is unaltered.
Hence planned saving cannot change. If savings increase, the income falls just enough to equate
planned saving and investment at the equilibrium.
In the long run once the economy has time to return to the level of potential output, if output
equals potential output, an increase in the desire to save will increase saving, and reduce
consumption, at potential output. Other adjustments may then induce investment demand to
rise to restore aggregate demand to its full-employment level. Hence, in the long run, society
may benefit from an increase in the desire to save. Investment will rise and the economy’s capital
stock and potential output may grow more quickly.
A-head: 16.7 The paradox of thrift
Learning Objective: Explain the paradox of thrift
Type: Application