Macro Quiz Preparation

Definitions and Short Answers

Be able to define (These all come from the flows tutorial)

Output
Income
Disposable Income
Consumption
Saving
Taxes
Government Purchases
Investment
Planned Investment
Fiscal Deficit
Fiscal Surplus

-- What do we mean by macroeconomic equilibrium?
-- Why does total output equal total income?
-- What is the difference between a stock and a flow?

Income-expenditure Model Problem

In a typical question, we would start with the model and find the equilibrium values for Y, Yd, C, and S.  Then there would be a change of some kind, either in government purchases (G) or in capital investment (Ip).  We would then find the new values of Y, Yd, C, and S.  A the end of Part 1.3 of the Macro Flows Tutorial are several examples of changes in G and new levels of these variable to practice on.

Here are some more questions for practicing numbers:

a.  Y = C + Ip + G
C = 100 + .9 (Y - T)
Ip = 100
G = 150
T = 100

Find equilibrium Y, Yd, C, S, and government deficit or surplus, if any.  Answer

b. Now cut government spending by 50 question (a) and solve again.  Answer

c. Set G=150 again, and try raising Ip to 200.  What happens?  Answer

d.  Y = C + Ip + G
C = 400 + .6 (Y - T)
Ip = 200
G = 600
T = 600

Find equilibrium Y, Yd, C, S, and government deficit or surplus, if any.  Answer

e. Raise government spending by 200 and solve again.  Answer

f. Go back to G = 600 and suppose that Ip dropped to 100.  Solve again.  Answer

That should be enough.  You can generate infinite numbers of these questions, if you are so inclined, by playing with a spreadsheet that graphs and solves these problems.

Telling a Story

What is supposed to be going on in the real economy that this model is showing us?  In general, three things:

1. Any initial change in G or in Ip is a change in demand for that amount of goods and services.  Output (Y) will respond.
2. But the story does not end there.  Output is also income.  So income will change.  And according to the consumption function in this model, any time income changes, consumption changes.  Consumption is a component of demand, and output will again respond, changing income, then consumption, then output again, so on and so on.  Of course each successive set of changes is smaller than the last, but when you add them all up you get a much bigger change in total output.
3. Changes in Y also produce changes in S.  Increases in spending, whether by government or by industry, are essentially self-financing, which means that enough new saving will appear for them to borrow.  In this model extra government borrowing never "crowds out" private borrowing.
Much more detail on this can be found in the Optional further notes on aggregate demand mentioned on the syllabus.

So what will you be asked?

A. In all cases, you will be asked to explain, carefully and step-by-step, what changes happened in the real economy to produce the change in equilibrium that you found in the problem.  Answering that basically involves points 1 and 2 above.  That is, I will look to be sure that you can explain in words that (i)  the change in G or Ip represents a change in demand for goods and services, (ii) this affects output -- that output adjusts to meet demand (iii) any change in output is automatically a change in income, which then affects consumption, and (iv) that this sets off a further long process of changes in output, as described above, so that the final change in output is a lot larger than the initial change in G or Ip.

B. In cases in which we raise government spending or trace through an increase in capital investment, I may also ask where the government or firms get the additional money they spend.  The answer is that they borrow it and that the higher level of income produces enough extra saving, as noted in point 3 above.