Tutorial 6
Chapter 8: Private sector demand: consumption and investment
Multiple choice questions
Question 1
Which ONE of the following is an important difference between aggregate
consumption and aggregate private investment?
a. The investment decision of firms is characterized by rationality, whereas
consumption decisions of households are much less rational.
Feedback: Incorrect. We assume that both are rational decisions.
Page reference: 195
b. Investment decisions are forward-looking and consumption decisions are
backward-looking.
Feedback: Incorrect. Both look forward.
Page reference: 195
*c. Consumption is relatively less variable than investment.
Feedback: Correct. Keynes characterized this volatility of investment as the changes
in the animal spirits of entrepreneurs.
Page reference: 195
d. Households are subject to a budget constraint, whereas firms are able to borrow.
Feedback: Incorrect. Both households and firms are subject to inter-temporal budget
constraints and can borrow.
Page reference: 195
Question 2
Point M is the endowment of Crusoe, who faces a real interest rate of r. Which ONE
of the following statements is NOT consistent with the figure above?
a. Crusoe’s wealth is equal to OB.
Feedback: Incorrect. This is true.
Page reference: 183
b. Crusoe would borrow in order to consume at point R.
Feedback: Incorrect. This is true.
Page reference: 183
*c. Crusoe is unable to consume his entire second-period income.
Feedback: Correct. Nothing stops Crusoe from consuming exactly his endowment
except his good sense, given his preferences.
Page reference: 183
d. The marginal rate of inter-temporal substitution is higher at M than at R.
Feedback: Incorrect. This is true.
Page reference 184
Question 3
If a household anticipates a permanent fall in income, which ONE of the following
will occur?
a. Saving will increase in the current period.
Feedback: Incorrect. Because its income will be lower today and tomorrow,
consumption today and tomorrow will drop by the drop in income.
Page reference: 183
b. Consumption-smoothing will be random.
Feedback: Incorrect. This is a nonsense answer. Shocks are random; behaviour
continues to be purposeful and rational.
Page reference: 183
*c. There will be a permanent fall in consumption that is of similar size to the
anticipated fall in income.
Feedback: Correct. See the discussion for Figure 8.3.
Page reference: 183
d. The real interest rate will increase.
Feedback: Incorrect. A household has no influence on the real interest rate.
Page reference: 183
Question 4
If the real interest rate were to decrease, why would the optimal capital stock for a
firm increase?
a. Because of the accelerator principle of investment.
Feedback: Incorrect. The accelerator kicks in when there is a change in output.
Page reference: 192, 194
*b. Because a lower real interest rate provides an incentive to invest, since the
marginal productivity of the existing capital stock would be higher than the marginal
cost of capital.
Feedback: Correct. See Figure 8.10.
Page reference: 192
c. Because the ‘animal spirits’ of entrepreneurs will become less volatile.
Feedback: Incorrect. The point of ‘animal spirits’ being exogenous is that they do not
depend upon the endogenous variables, output and interest rates.
Page reference: 192, 196
d. Because the lower interest rate would stimulate consumption.
Feedback: Incorrect. This is a nonsense answer.
Page reference: 192
Question 5
Suppose that, for current and expected future incomes, a household is observed to
borrow at the current real rate of interest. If the real rate of interest were to increase,
what would we expect this household to do?
a. To decrease its saving this period.
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Feedback: Incorrect. See Figure 8.6(a). Note that the household that is borrowing to
consume has negative saving. Since current income has not changed, consumption
going down means that less will be borrowed, i.e. the net saving gets less negative,
meaning that the net saving will increase.
Page reference: 188
b. To decrease both its saving and its consumption this period.
Feedback: Incorrect. See Figure 8.6(a). Note that the household that is borrowing to
consume has negative saving. Since current income has not changed, consumption
going down means that less will be borrowed, i.e. the net saving gets less negative,
meaning that net saving will increase.
Page reference: 188
*c. To decrease its consumption this period.
Feedback: Correct. See Figure 8.6(a). Both the income and substitution effect of an
increase in the real interest rate work to reduce this period’s consumption.
Page reference: 188
d. Neither to decrease or increase its consumption in this period.
Feedback: Incorrect. See Figure 8.6(a). Both the income and substitution effect of an
increase in the real interest rate work to reduce this period’s consumption.
Page reference: 188
Question 6
Assuming that v is a constant value and larger than 1, then the relationship between
current investment I1 and expected growth in output (Y2 – Y1): I1 = v (Y2 – Y1) is an
explanation for which ONE of the following?
a. Lifetime consumption being relatively smooth compared to fluctuations in
aggregate output.
Feedback: Incorrect.
Page reference: 194
b. The multiplier effect.
Feedback: Incorrect.
Page reference: 194
c. The volatility of aggregate saving.
Feedback: Incorrect.
Page reference: 194
*d. The accelerator effect.
Feedback: Correct.
Page reference: 194
Open question: Exercise 2 from the book (only first part, not national level).
2. Use figure 8.3 in the book. An increase in future income affects present and future
consumption. First period income Y1 is unchanged, while expected income in period 2
increases from Y2 to Y2’. Consumption rises in both periods (point R’) as the
household borrows now against future income to raise consumption in period 1 as
well. This is an example of what is called consumption smoothing - the variation of
consumption over the two periods is much smaller than that of income.
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Extra questions: Exercises 1, 3, 5 and 11 from the book.
The expression for C 2* is (1  r )
Y 
 
Y1  2  and for C1* equals

1  
1 r 
Y 
1 
Y1  2  . Obtain the numerical solutions for both consumption levels by

1  
1 r 
substituting the adequate numbers for r, income in period 1, income in period 2, and β
into these formulas.
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3. According to the permanent income hypothesis, people base consumption on what
they consider to be their sustainable or "permanent" income, rather than on transitory
movements of current income. As a result, increases and decreases in income which
people see as temporary have little effect on their consumption spending.
Consumption theory based on utility maximization usually assumes that consumption
in each period is a normal good and the marginal utility of consumption is positive but
declining in each period. In general, it predicts that consumption is smoothed relative
to income – which is also a central prediction of the permanent income theory. In
some special cases, the utility maximizing level of consumption is a simple function
of a measure of lifetime income and is independent of current income. Consumption
theory does not however predict a constant level of consumption over time – the path
may be rising or falling, depending on the impatience of the consumer relative to the
rate of return on savings. Thus, consumption theory can be seen as providing the
theoretical (microeconomic) foundations of the permanent income hypothesis, but is
in fact much more general.
5. Because purchases of durable goods are like saving (buying a washing machine
which you can use tomorrow instead of buying it tomorrow), they should increase in
the face of temporary increase in income, and decrease (i.e. purchases are postponed)
in the opposite case. This will be especially true if the secondary and rental markets
for consumer durables do not function properly or do not exist. The greater the
durability, the stronger is this effect.
11. The higher taxes in these countries now and in the future will reduce consumers’
permanent income in these countries. Since under the permanent income hypothesis
consumption today and tomorrow is proportional to permanent income, consumption
today and tomorrow will be lower. Hence the higher taxes in these countries now and
in the future will lead to permanently lower consumption levels in these countries.
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Chapter 9: Money and monetary policy
Multiple choice questions
Question 1
In the two figures below, we see the same demand for nominal money, but two
different supplies of nominal money, corresponding to different monetary policies.
Which ONE of the following can we conclude?
*a. The interest rate is endogenous on the left and the money supply is endogenous on
the right, holding the price level constant in both diagrams.
b. The money supply is endogenous on the left and the interest rate is endogenous on
the right, holding the price level constant in both diagrams.
c. The price level is endogenous on the left and the interest rate is endogenous on the
right, holding the quantity of money constant in both diagrams.
d. The price level is endogenous on the left and the money supply is endogenous on
the right, holding the real rate of interest constant in both diagrams.
Feedback: See discussion of Figure 9.11.
Page reference: 224
Question 2
The reserve multiplier is no greater than 1/rr, where rr = the required reserve ratio, for
which ONE of the following reasons?
Page reference: 213
a. Banks charge higher interest on loans than they pay to depositors, and banks hold
prudential reserves.
Feedback: Incorrect. The first part is true (banks are financial intermediaries), but
this is not the reason behind the bounds of the money multiplier.
b. Banks sometimes reject loan applications as too risky and must keep their reserves
at the central bank.
Feedback: Incorrect. It is the fact that reserves are held, not where they are held, that
matters.
*c. Banks are only required to keep a minimum fraction of their deposits as reserves
by regulation and may choose to hold a higher fraction when additional security is
judged prudential.
Feedback: Correct. Note the distinction between prudential reserves and required
reserves!
d. By borrowing, households can spend more than their income in a period, but never
more than their creditworthiness.
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Feedback: Incorrect. This answer confuses spending decisions by households with
the linkage between bank reserves and bank lending.
Question 3
Open market operations usually take the form of a [(A)_____________] from the
central bank to commercial banks, but can also involve purchases and sales of
[(B)____________].
a. (A) money order; (B) reserves
b. (A) government deficit; (B) short-term loans
c. (A) transfer payment; (B) commodities
*d. (A) short-term loan; (B) assets
Feedback: (A) short-term loan (à la ECB); (B) assets (à la US Fed).
Page reference: 218–19
Question 4
Suppose that the Taylor rule for a central bank is as shown below.
Y Y 
i  i  1.5        0.5  

 Y 
If the GDP gap were equal to minus 0.06 and the actual inflation rate were
[(A)______], the central bank’s target inflation rate, the central bank would
[(B)_________] the interest rate from the central bank’s neutral interest rate.
a. (A) 0.02 below; (B) not change
b. (A) 0.02 below ;(B) increase
*c. (A) 0.02 above;(B) not change
d. (A) 0.02 above ;(B) increase
Feedback: Plugging the correct numbers into the right places and you find that the
correct answer is C.
Page reference: 225
Question 5
Which ONE of the following is the purpose of requiring banks to maintain a
minimum net worth in relation to their volume of deposits?
Page reference: 228
*a. To increase the likelihood that a bank will survive, even if a sudden,
unanticipated, and severe loss in value of some its assets were to occurs.
Feedback: Correct. This is an important source of protection against potentially toxic
assets.
b. To prevent a speculative acquisition of the bank by another bank.
Feedback: Incorrect. There is no link between the assumed regulatory requirement
and this.
c. To provide funds that pay for deposit insurance.
Feedback: Incorrect. This confuses a balance sheet item with a mandated recurring
cost.
d. To provide a private buffer of funds that is available for assisting other banks to
survive a bank run.
Feedback: Incorrect. This response confuses the lender of last resort function of a
central bank with this particular form of bank regulation.
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Open question: Exercise 1 and 9 from the book.
1. Using equation (9.3), we note that, in the long run, the Taylor rule implies that the
interest rate is constant, because inflation and the output are at their long-run levels.
This implies that k(i) is constant. Then money must grow at the same rate as the
nominal GDP PY, that is at the sum of the rate of inflation and the trend growth rate
ΔM ΔP ΔY
(
). It then follows that the money growth target is 5%. With reserves
=
+
M
P
Y
being a constant fraction of deposits and deposits growing at the same rate as the
money stock when there is no cash in the economy, i.e., C = 0, reserves too must
grow at 5%, independently of the size of the reserves ratio.
9. When π - π = 2%, the Taylor rule predicts i = 4 + 1.5*2 + 0.5*0 = 7%. With an
output gap of 3%, we add 0.5*3 to find 8.5%. If the output gap is -2%, we subtract
0.5*2 to get 6%.
Extra questions: Exercises 5, 8, 11 and 12 from the book.
5. Under the money growth strategy, if the money supply target remains unchanged,
the interest rate will have to rise. Under the inflation targeting strategy, it is the money
supply that will increase, with the interest rate unchanged.
8. Deposit insurance guarantees that depositors (savers) will recover their money if
their bank fails. This makes it pointless to run on the bank, stay in long lines and get
money out. Unfortunately, most schemes set a ceiling on how much can be recovered,
so depositors still have an incentive to withdraw any amount in excess of the ceiling.
In addition, because the central bank may set a temporary limit below the ceiling, and
because it may take time for the insurance to pay out, depositors may still get nervous
and panic.
11. Each bank knows that it can borrow from the ECB at the marginal lending facility,
so it would not pay a higher interest rate elsewhere. Similar, each bank knows that it
can earn the marginal deposit rate, so it has no reason to lend at any lower rate.
12. As can be seen from the central bank’s balance sheet in Figure 9.4, the purchase of
public bonds from commercial banks increases the amount of securities on the assets
side. On the liabilities side, either the currency in circulation increases if the
commercial banks receive cash, or the deposits by commercial banks increase if the
value of the public bonds is credited to the commercial banks’ account. In any case,
the monetary base increases. However, if the commercial banks hold the extra
reserves as deposits instead of lending to their customers, the increase in the monetary
base M0 does not lead to an increase in M1 and is therefore no threat to inflation. It
may become a threat though at the moment where commercial banks use their excess
reserves to raise their supply of loans, thus stimulating consumption and investment.
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