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The value of equilibrium consumption
Part 1: AE Problem (11 questions worth 3 points each for a total of 33 points).
Suppose the initial conditions of the economy are characterized by the following equations in black font. We then shock the economy as shown in the red font.
What is the value of Investment: I =
Fill in the intercept and slope values to correctly complete the AE equation: AE =
The value of equilibrium output (Y) =
The value of equilibrium consumption (C) =
We now incur shocks to the economy as provided in the red font. Use these new conditions to get expressions for the Consumption function, Investment and the AE equation.
Fill in the intercept and slope values to correctly complete the new consumption function: C =
What is the new value of Investment: I =
Fill in the intercept and slope values to correctly complete the new AE equation: AE =
The new value of equilibrium output (Y) =
The new value of equilibrium consumption (C) =
NOTE: There is no graphing component to be collected for this homework. However, you should be comfortable creating two separate graphs from the above questions. You should be able to:
1. Graph the consumption function both before and after the shock on one graph, and also plot equilibrium consumption and output values both before and after the shock.
2. Graph the AE equation both before and after the shock on one graph, and also plot equilibrium output Y both before and after the shock.
Are your results above consistent with the new economy?
Pretend that you have a lemonade stand and that the demand for lemonade in your neighborhood is estimated to be: Q = 60 – 100 P
Just like in the lecture, you get all the materials to make the lemonade for free so we assume that the costs of production are zero. Your goal, your objective, is to maximize profits which is the same as maximizing total revenue given the zero cost assumption.
The profit (revenue) maximizing price is
The profit maximizing quantity (in cups) of lemonade is
The corresponding maximum profit is $
Suppose that there was a demand shock so that the new estimated demand function for lemonade in your neighborhood changes to:
Q = 100 – 100 P
A demand curve would change like this due to:
The new profit (revenue) maximizing price is
The new profit maximizing quantity (in cups) of lemonade is
The new corresponding maximum profit is $
Imagine that you kept the “sticky” lemonade price even though demand has changed (use the price you found in #12). What is the quantity sold now?
NOTE: There is no graphing component to be collected for this homework. However, you should be comfortable creating two separate graphs from the above questions in part 2. You should be able to:
1. Draw a demand curve graph showing both the original and new demand curves. Label equilibrium price and quantity in in both cases.
2. Draw the total revenue curves for both cases in a graph directly below the demand curve graph (remember the horizontal axes for the demand curve graph and the total revenue graph are the same).
Again imagine that you kept the “sticky” lemonade price even though demand has changed (use the price you found in #12). What is the profit now? $
Consumption is positively related to stock market wealth but negatively related to taxes and tax rates.
If aggregate expenditures rise unexpectedly, then inventories will also rise unexpectedly.
Services are the most interest rate sensitive component of consumption.
Investment is the most cyclical component of aggregate expenditures.
The ‘job-loss’ recovery occurred following the 2001 recession.
Negative real interest rates imply that if you save today, you can purchase a smaller basket of goods and services in the future, relative to the basket you could have consumed today.
The higher the marginal propensity to consume the more powerful tax policy is to influencing consumption.
According to the results of the estimated consumption function, consumption is more sensitive to changes in stock market wealth relative to changes in real estate wealth.
The sensitivity parameter in the consumption function that measures how sensitive consumption is to changes in consumer confidence is referred to as the marginal propensity to consume.
In a consumption function with income (Y) on the horizontal axis and consumption (C) on the vertical axis, a fall in the real rate of interest (all else constant) will cause a shift upward of the consumption function.
In a consumption function with income (Y) on the horizontal axis and consumption (C) on the vertical axis, a rise in the price level (all else constant) will cause a shift upward of the consumption function.
A fall in tao, the effective tax rate on capital will result in the investment demand function shifting to the right.
The slope of the investment demand function indicates how sensitive investment is to changes in real interest rates. The ‘flatter’ the investment demand function, the less sensitive investment is to changes in the real rate of interest, all else constant.
A rise in imports, all else constant, will increase net exports.
If the US is growing faster than the rest of the world, then all else constant, the trade deficit will widen (get more negative assuming we were running a trade deficit to begin with).
If the inflation rate rises in China so that it exceeds that of the US, then net exports for the US should increase, all else constant.
If the exchange rate between the US dollar and Japanese yen changes from $1 = 100 yen to $1 = 80 yen, then US exports to Japan will become more expensive to Japanese importers.
We argued that cash flow (CF) increased during the Great Recession and thus, had a positive effect on investment.
In a consumption function with income (Y) on the horizontal axis and consumption (C) on the vertical axis, a rise in stock market wealth, all else constant, will result in a movement along the consumption function.
The stronger the US dollar is relative to the rest of the world, all else constant, the larger the net exports in the US.
One reason that the aggregate demand curve slopes downward is that when prices rise, say in the US, the relative price of imports fall and thus, US citizens substitute away from domestically produced goods toward imported goods and thus, GDP in the US will fall (all else constant).
Suppose the value of the US dollar changes from $1 = 1.2 euros to $1 = 1.30 euros. This being the case, imports from the US to Europe, have become more expensive to European citizens, all else constant.
One reason the aggregate demand curve slopes downward is due to the fact that if the price level falls, real money balances rise, all else constant, interest rates will fall causing an increase in consumption and investment.
Assuming that natural gas for firm X is an important input to the production process, an increase in the availability of natural gas that lowers the price of natural gas, will result in a leftward shift of firm X’s supply curve.
According to the lecture on the cyclical properties of the aggregate supply curve, I argued that aggregate demand side policy works better, in terms of influencing output, when the economy is operating at near full employment output relative to when the economy is operating at levels of output well below full employment.
If labor markets become “loose” and wages fall, all else constant, the short run aggregate supply curve will shift to the left.
The more ‘sticky’ nominal wages and other input costs are, the steeper the slope of the aggregate supply curve and therefore, the less effective demand side policies in terms of effecting real output.
If the US economy is growing faster that the rest of the world, then we would expect a surge in US exports.
Suppose that expected inflation is 5% and thus, nominal wages rise, along with all other input prices by 5%. Suppose also, that actual inflation over this period was only 2%. In terms of the behavior of the short-run aggregate supply curve, it would shift up given the expectations of higher inflation and then shift downward to adjust for the actual rate of inflation.
The more sensitive consumption is to real wealth, the steeper the aggregate demand curve.
During the Great Recession, we argued that the aggregate expenditure curve shifted downward and the short-run aggregate supply curve and the aggregate demand both shifted to the left.
Anything that shifts the investment demand curve to the right will also shift the aggregate demand curve to the right.
The Obama administration in 2013 let a tax holiday expire which effectively increases income taxes for all workers who pay into social security. The effect of this increase in taxes, all else constant, would shift the consumption function down, the aggregate expenditure curve down, and the short-run aggregate supply curve to the left.
Given that the working age population is shrinking in Japan, our discussion about the determinants of the potential growth rate of the economy suggests that this demographic reality would lower the potential growth rate of the economy for Japan, all else constant.
One reason the short-run aggregate supply curve slopes upward is due to the ‘stickiness’ of input prices relative to output prices. We saw this in the plastering example when we let output prices rise and kept nominal wages constant. This being the case, the firm’s profit maximizing output rises with the rise in prices, all else constant.
According to our discussion about the cyclicality of the aggregate supply curve, the closer the economy is to potential output, the more Keynesian the world and thus, the more effective aggregate demand side policies are in terms of effecting real GDP.
If output prices rise without the nominal wage rising, then real wages rise and workers are willing to work more. This is one of the main reasons that the short-run aggregate supply curve slopes upward.
When we discussed the stagflation of the 1970s, we argued that policymakers should have acted more aggressively with expansionary policies the fight the recession that occurred during that time.
The more flexible wages and prices, the steeper the short-run aggregate supply curve. In fact, if prices and wages (and other inputs costs) are perfectly flexible then we are in a ‘classical’ world, where the short-run aggregate supply curve is vertical.
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