Workbook For Chapter 23 Of Frank and Bernanke’s Principles of Economics. Part 1 Hints for the Review Questions Question 5 You are asked to reproduce Figure 26.1 of the textbook. Make sure you follow the question’s instructions slavishly: • label the axes; • discuss the economic meaning of movements along the curve; • discuss the meaning of shifts of the curve. “Shifting the curve” is really the same thing as changing the value of the vertical intercept (C-bar). What does the intercept of the consumption function represent, in economic terms? • give an example of what would lead to shifts of the curve (changes of the intercept). Question 6 Students often confuse the consumption function with the planned aggregate expenditure function. The look similar because they are both linear, they have the same slope (= the marginal propensity to consume), and they both have a positive intercept. But they are quite different. • The consumption function’s intercept is C-bar, which only represents autonomous consumption, that is, spending by households that doesn’t depend on income. • The PAE’s intercept is (C-bar + IP + G + NX), autonomous expenditure, that is, spending that doesn’t depend on income by all sectors of economy.1 So, for example, a change in IP will cause a shift of the PAE curve, but not of the C function … because IP is part of expenditure but it is not part of consumption (Why?). The question asks you to reproduce Figure 26.3. Make sure to label the axes, the curves, the slopes of the curves, their vertical intercepts, and the point where they meet. Once you’ve drawn the graph, explain the economic significance of the curves. 1 Here we assume that there’s no effect of GDP on investment, government expenditures, or net exports, or even tax revenues. This is very unrealistic (higher GDP should increase IP because it increases sales; reduce G because it makes it less necessary; reduce NX because it encourages imports; and increase tax revenues if there’s an income tax). But here we simplify the analysis by assuming IP, G, and NX are autonomous, that is, independent of GDP.Equilibrium output would be the solution of this system of equations (PAE = C+I+G+NX, and Y=PAE), the value of Y at the intersection of the two curves. Drawing Graphs in MS Word This is a very useful skill, but one that takes practice. Go to MS Word Help (press the F1 key), click on the Table of Contents, on Working with Graphics and Charts, and then on Shapes and Drawing Objects for an introduction. To begin, go to View|Toolbars and select Drawing. You can draw the axes of graphs, and any other straight line, with the “line” button. You can label axes, curves, etc., with the “textbox” button (click on it, and then draw the textbox where you want it). Word will introduce a Drawing Canvas into your documents every time you select a Drawing tool. This is useful because otherwise, if you move your document around, the graph will move with the paragraphs, and different parts of the drawing may move differently. The Drawing Canvas allows you to keep all the parts together. The drawing canvas also provides a frame-like boundary between your drawing and the rest of your document. By default, the drawing canvas has no border or background, but you can apply formatting to the drawing canvas as you would any drawing object. By default, Word places a drawing canvas in your document when you insert a drawing object (except WordArt). The canvas is automatically positioned to be inline with the text of your document. (I find it annoying, because I’ve learned to deal with the problem and the Drawing Canvas takes up too much space. To turn it on or off, use Tools|Options, the General tab, and then select or clear the “Automatically create drawing canvas when inserting AutoShapes” check box.) Step-by-steps for the Problems Fill in your answers to the selected problems here. Do the rest of the assigned problems on a separate piece of paper. Problem 1 Hints: • Define Investment. • Remember inventory investment is changes in inventory, not in the level itself. • Define inventory, and how a firm would accumulate it or reduce it. Problem 2 Data on before-tax income, taxes paid, and consumption spending for the Simpson family in various years are given below.a. Fill in the following table. Before-tax Income ($) Taxes paid ($) After-tax Income ($) Consumption Spending ($) 25,000 3,000 20,000 27,000 3,500 21,350 28,000 3,700 22,070 30,000 4,000 23,600 Why do taxes rise when before-tax income rises? _________________________ ___________________________________________________________________ . b. Graph the Simpson’s consumption function and find their household’s marginal propensity to consume. Put after-tax income on the horizontal axis and consumption on the vertical axis. Label the axes. Draw the function as a dark, solid line ( ). c. What is the vertical intercept of this function? _____________. What is the slope (=vertical change / horizontal change)? ___________________________ . Suppose after-tax income increases by $1000. Given the slope, what will be the change in consumption? __________________________________________ . 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 (in thousands) (in thousands)d. Given your answers to (c), how much would you expect the Simpsons to consume if their income was $32,000 and they paid taxes of $5000? _________ . e. Homer Simpson wins a lottery prize. As a result, the Simpson family increases its consumption by $1000 at each level of after-tax incomBefore-tax Income ($) e. (“Income” does not include the prize money. It is considered a change in wealth, similar to an increase in the value of his house.) Fill in the following table: Taxes paid ($) After-tax Income ($) Consumption Spending ($) before lottery prize. Consumption Spending ($) after lottery prize. 25,000 3,000 20,000 27,000 3,500 21,350 28,000 3,700 22,070 30,000 4,000 23,600 On the previous page, draw the new consumption function, using a dark, hatched line ( ). How does the change in Homer’s wealth change affect the graph of their consumption function? ______________________________________________ . How does it affect the marginal propensity