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econ101fall11exam1practicebsoln

econ101fall11exam1practicebsoln - 180.101 Principles of...

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180.101 Principles of Macroeconomics, Fall 2011 First Term Exam : Practice Problems Question 1 . Suppose you have the following consumption function C = α + βY + γZ where α > 0 is a constant, 0 < β < 1, γ < 0, Z is some variable that affects consumption and Y is income. (a) Explain the economic meaning of α , β , and γ . α is autonomous consumption, we are used to seeing it as ¯ C . It represents the quantity of consumption that depends neither on income nor on Z . β is the marginal propensity to consume (MPC) with respect to income Y , we are used to seeing it as b . For every additional dollar of income in society, there will be β more dollars of aggregage consumption. γ can only be described as the slope of the consumption function with respect to Z . If Z is some variable denominated in dollars, then γ is the marginal propensity to consume from Z , otherwise it is almost (but note quite) an MPC. (b) Plot C against Y . Describe the intercept and the slope. Note that we are holding Z fixed. The intercept reflects the sum of autonomous consumption, α and γZ . Slope, β , reflects MPC with respect to income, Y . (c) Explain what will happen to the consumption curve if Y increases. Show your answer graphically. Nothing will happen to the consumption curve. Increasing Y is represented by a shift along the curve, not a shift in the position of the curve. This corresponds to households purchasing more consumption goods as they receive more income. 1
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(d) Explain what will happen to the consumption curve if Z decreases. Show your answer graphically. When Z decreases, this is effectively an increase in the intercept of the curve. Consumption will rise equally at every level of income, so the entire curve shifts up uniformly, with no change in slope. (e) Suppose by using the above formula we calculated consumption in 2009 to be 100 and 150 in 2011. Calculate the growth rate of consumption between 2009 and 2011. C 2011 - C 2009 C 2009 = 150 - 100 100 = 1 2 (or 1 2 × 100 = 50 percent). This is a biennial, rather than annual, growth rate. (f) Explain what it means for the economy to be in recession. Explain what it means for the economy to be expansion. Do you have enough information to establish whether the economy is in recession or expansion from your answer to part (e)? What other information would you need to figure this out? A recession is when real income falls for two or more consecutive quarters. An expansion is when real income rises for two or more consecutive quarters. Phrased differently, if the growth rate of real income is less than zero for two consecutive quarters ( Δ Y t Y t - 1 < 0), the economy is in a recession; if the growth rate of real income is more than zero for two consecutive quarters ( Δ Y t Y t - 1 > 0), then the economy is in an expansion. No, we can’t tell whether the economy is in an expansion or recession based on the provided data. While it is tempting to say that real income increased during this period, which motivated the observed increase in consumption, we don’t know what happened to Z over this time period.
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