# The diagram depicts a consumption function of an economy, discussion help

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The diagram depicts a consumption function of an economy, where C is the aggregate consumption spending, Y is the current income of the economy and c0 is the fixed (or autonomous) consumption such that c0 > 0. Assume that households that are not credit-constrained would completely smooth their consumption. Which of the following statements is correct?

 A. If all households were not credit-constrained, and all income changes were perceived temporary, then the aggregate consumption line would be horizontal. B. In times of credit crunch when the banks become less willing to lend, the aggregate consumption line would become flatter. C. If a higher proportion of households have “weakness of will”, then the aggregate consumption line would be flatter. D. If the current income falls to zero, there will be zero consumption.

 Feedback: In a credit crunch more households would become credit-constrained. Therefore the line would become steeper. Weakness of will means that when there is an expected fall in the income, the households are less likely to adjust their consumption ahead of the fall, in order to build up some savings so that they can smooth consumption. In this case their marginal propensity to consume would be higher, implying a steeper aggregate consumption line. c0 > 0 means that even if the current income is zero, the households will consume a strictly positive amount.
##### Question 2 of 15
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If the multiplier during a recession is equal to 2, then if the government wants to increase GDP by \$500 billion it should increase spending by:

 A. \$100 billion. B. \$200 billion. C. \$250 billion D. \$1 trillion

 Feedback: The multiplier increases the initial spending by the government (or consumers or businesses) by increasing spending and therefore income in the economy.
##### Question 3 of 15
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Assuming that there is no government spending or trade, an economys aggregate demand is given by its domestic consumption C and investment I, AD = C + I = c0 + c1Y + I.

In the economys goods market equilibrium this equals its output: AD = Y. Solving for Y this yields:

Y = [1/(1-c1)] (c0+ I)

Given this equation, which of the following statements is correct?

 A. The multiplier is given by 1  c1. B. The boost in the economys output is the same whether the aggregate demand shock comes from an increase in investment I or in autonomous consumption c0. C. The larger the marginal propensity to consume c1, the smaller the multiplier. D. If c1 = 1/3, then a £1 million increase in investment would result in a £2 million increase in the output.

 Feedback: The multiplier is given by 1 / (1  c1). Larger c1 means smaller 1  c1, which in turn means larger multiplier 1 / (1  c1). When c1 = 1/3 then 1 / (1  c1) = 1.5, and therefore a £1 million increase in I would result in a 1.5 million increase in Y.
##### Question 4 of 15
1.0/ 1.0 Points

Assume that in France and Germany, it is not possible for a household to increase its borrowing based on an increase in the market value of their house. In addition, a large down-payment (as a per cent of the house price) is required for house purchase. On the basis of this information, which of the following statements is correct when there is a rise in the house price?

 A. There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. B. Would-be homeowners would increase saving, leading to their reduced consumption. C. A rise in the house price leads to an increase in human capital. D. A rise in the house price is likely to lead to an increase in consumption in France and Germany.

 Feedback: Correct
##### Question 5 of 15
1.0/ 1.0 Points

In the US and the UK, loans are widely available based on a rise in home equity. Additionally, unlike in France and Germany where large downpayments (as a percentage of the house price) are required, in the US and the UK only small downpayments are required for house purchases. On the basis of this information, which of the following statements is correct for the US and the UK when there is a rise in the house price?

 A. There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. B. There would be no effect on the consumption of the existing homeowners who are not credit-constrained. C. Would-be homeowners would increase saving and reduce their consumption more than they would in France and Germany. D. A rise in house price is likely to dampen consumption in the US and the UK.

 Feedback: Correct
##### Question 6 of 15
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Which of the following statements is correct regarding the multiplier?

 A. If two countries were identical except for the share of credit-constrained households, then the country with the higher share would have a smaller multiplier. B. The multiplier is constant over a business cycle. C. An increase in export leads to a higher multiplier. D. Taxation and imports are leakages from the circular flow of income, which contributes to lowering of the multiplier.

 Feedback: A higher share of credit-constrained households means higher marginal propensity to consume. Therefore the multiplier will be larger. The proportion of credit-constrained households would vary over a business cycle. The multiplier would therefore vary accordingly. The multiplier in an open economy depends on the marginal propensity to consume, the marginal propensity to import and the income tax rate. The level of export does not affect the multiplier (it affects the level of the aggregate demand curve, but not the slope).
##### Question 7 of 15
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Given that imports represent a “leakage” out of the economy and reduce the multiplier, if the following countries have the given rates of Imports/GDP which is likely to have the largest multiplier (assuming all else is the same):

 Country Imports/GDP Belgium 82.1 Canada 33.4 Denmark 46.6 Ireland 96.7 Netherlands 71.4
 A. Belgium B. Canada C. Ireland D. Netherlands

 Feedback: Higher imports mean less of the money is spent on domestic production and so “escapes” the economy.
##### Question 8 of 15
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Which of the following statements is correct regarding fiscal policy?

 A. Expansionary fiscal policy (e.g. increasing the government deficit or reducing the surplus) always has a stabilizing effect for the economy. B. Unemployment benefits and taxes automatically increase government spending and cut taxation in a downturn, while they trim spending and raise taxes in a boom. These are, therefore, automatic stabilizers. C. In a recession the aim of a government fiscal expansion is to over-ride the effects of automatic stabilizers. D. As a family worried about mounting debts should cut spending and save more, so should an economy adopt austerity measures when its debt level is high to restore its public finances to balance.

 Feedback: During a boom an expansionary fiscal policy may be destabilizing. In a recession the government would use fiscal expansion to enhance the effects of automatic stabilizers. This is the paradox of thrift; if everyone stops consuming then that creates further unemployment, causing a vicious cycle.

#### Part 2 of 2 – Chapter 14 0.0/ 7.0 Points

##### Question 9 of 15
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Which of the following statements is correct regarding inflation and deflation?

 A. Borrowers benefit from deflation as the value of their debt decreases in real terms. B. Inflation transfers wealth from lenders to borrowers. C. Falling prices benefit consumers and are therefore always good for the economy. D. Inflation makes it difficult for consumers and firms to attain the message about scarcity of resources (sent by relative prices) and is therefore always bad for the economy.

 Feedback: Deflation increases the real value of nominal debts. This is undesirable for borrowers. Falling prices certainly benefit consumers who have constant nominal income. However if they postpone consumption in expectation of further price falls (particularly of durable goods such as cars) then this leads to a fall in aggregate demand for the economy, which could lead to more deflation. It is true that in cases of high and volatile inflation it is hard to separate relative prices changes from the noise of erratically rising prices. However, under mild inflation adjustments in economic activities can take place without losers experiencing falling nominal wages, which is beneficial to the economy (greasing the wheels of the labour market).
##### Question 10 of 15
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Consider a scenario where the Bank of England views the UK economy to be overheating and is attempting to slow the economy down using monetary policy. Which of the following statements is correct regarding the effects of an interest rate rise?

 A. It leads to higher bond prices, which result in higher demand for UK bonds. B. It leads to higher demand for GBP, which results in an appreciation of GBP. C. It leads to the UK exports becoming cheaper and imports becoming more expensive. D. It has opposing effects to the UKs aggregate demand (AD) of discouraging investment, which lowers AD, and cheaper imports, which boosts AD.

 Feedback: An interest rate rise does lead to higher demand for UK bonds, but due to their lower prices. Higher interest rate leads to lower bond prices, resulting in higher demand for UK bonds. This in turn leads to GBP appreciation, making UK imports cheaper and exports more expensive, which depresses aggregate demand in the UK. Cheaper imports mean higher leakage. This reduces aggregate demand.
##### Question 11 of 15
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The diagram depicts the Phillips curve and the indifference curves of an economy. This economy has an independent central bank with an inflation target of 2%. Based on this information, which of the following statements is correct?

 A. The central bank will try to achieve zero unemployment while keeping the inflation at 2%. B. The shape of the indifference curves indicates that the central bank is willing to trade higher inflation with lower unemployment at all times. C. Consider an aggregate demand shock that increases unemployment. Without monetary or fiscal policy to counter the negative bargaining gap, the Phillips curve would shift down. D. Consider an aggregate demand shock that increases unemployment. The central bank would raise the interest rate to put downward pressure on inflation, in order to bring it back to the target rate.

 Feedback: The Phillips curve means that this is not achievable. The inflation-stabilizing unemployment rate is shown to be 6%: this is the outcome of the wage and profit curves. This is true in the upward-sloping parts of the indifference curves. Where the indifference curves are downward-sloping (e.g. when unemployment is higher than 6% and the inflation is lower than 2%), the trade-off is between higher unemployment and higher inflation. For an aggregate demand shock that increases unemployment, inflation will fall below the target along the Phillips curve. Therefore the central bank should lower interest rate to put upward pressure on inflation, in order to bring it back up to the target rate.
##### Question 12 of 15
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The book gives an analogy of an economy experiencing disinflation as similar to a car that is:

 A. Speeding up. B. Going in reverse. C. Stopped. D. Slowing down but still going forward.

 Feedback: Disinflation is not the same as deflation (negative inflation), so inflation is still generally positive.
##### Question 13 of 15
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In data for the United States, the Phillips Curve:

 A. Shows a very close relationship between the unemployment rate and inflation. B. Shows a varying relationship between the unemployment rate and inflation that seems to have broken down in the late 1970s and 1980s. C. Shows no relationship between the unemployment rate and inflation. D. Shows a relationship in which inflation usually increases as the same time as the unemployment rate.

 Feedback: Check out Figure 14.6 in section 14.5 showing data from the U.S> from 1960s to 2010s.
##### Question 14 of 15
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When an economy expects positive inflation, the Phillips Curve shifts up and actual inflation is:

 A. Always equal to expected inflation. B. Always equal to the bargaining gap. C. Equal to expected inflation plus the bargaining gap. D. Equal to expected inflation minus the bargaining gap.

 Feedback: Remember, if firms and workers expect inflation, they will build that in to their wage demands and prices. But they still have to contend with the business cycle which means they may not be at the labor market equilibrium.
##### Question 15 of 15
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Monetary policy can affect aggregate demand and inflation through all of the following channels EXCEPT:

 A. The exchange rate B. Residential investment C. Expectations/confidence D. Taxes and government spending