b.A rise in the cost of borrowing is equivalent to a rise in
the interest rate: fewer investment spending projects are
now profitable to producers, whether they are financed
through borrowing or retained earnings. As a result, pro-
ducers will reduce the amount of planned investment
spending.
c.A sharp increase in the rate of real GDP growth leads to
a higher level of planned investment spending by produc-
ers as they increase production capacity to meet higher
demand.
d.As sales fall, producers sell less, and their inventories
grow. This leads to positive unplanned inventory
investment.
Tackle the Test:
Multiple-Choice Questions- d
- c
- b
- d
- a
Tackle the Test:
Free-Response Question - 1.The interest rate is the price (or opportunity cost) of
investing, thus they are negatively related.
2.Expected future real GDP—if a firm expects its sales to
grow rapidly in the future, it will invest in expanded pro-
duction capacity.
3.Production capacity—if a firm finds its existing production
capacity insufficient for its future production needs, it will
undertake investment spending to meet those needs.
Module 17
Check Your Understanding- a.This is a shift of the aggregate demand curve. A decrease
in the quantity of money raises the interest rate, since
people now want to borrow more and lend less. A higher
interest rate reduces investment and consumer spending
at any given aggregate price level, so the aggregate
demand curve shifts to the left.
b.This is a movement up along the aggregate demand curve.
As the aggregate price level rises, the real value of money
holdings falls. This is the interest rate effect of a change
in the aggregate price level: as the value of money falls,
people want to hold more money. They do so by borrow-
ing more and lending less. This leads to a rise in the
interest rate and a reduction in consumer and investment
spending. So it is a movement along the aggregate
demand curve.
c.This is a shift of the aggregate demand curve.
Expectations of a poor job market, and so lower average
disposable incomes, will reduce people’s consumer spend-
ing today at any given aggregate price level. So the aggre-
gate demand curve shifts to the left.
d.This is a shift of the aggregate demand curve. A fall in tax
rates raises people’s disposable income. At any given
aggregate price level, consumer spending is now higher.
So the aggregate demand curve shifts to the right. - a.A market basket determined 10 years ago will contain
fewer cars than at present. Given that the average price of
a car has grown faster than the average prices of other
goods, this basket will underestimate the true increase in
the price level because it contains relatively too few cars.
b.A market basket determined 10 years ago will not contain
broadband Internet access, so it cannot track the fall in
prices of Internet access over the past few years. As a result,
it will overestimate the true increase in the price level. - Using Equation 15-2, the inflation rate from 2006 to
2007 is (207.3 −201.6)/201.6 × 100 =2.8%.
Tackle the Test:
Multiple-Choice Questions
- d
- c
- e
- b
- b
Tackle the Test:
Free-Response Question
- GDP Deflator CPI
2004–05: (3.2/96.8) × 100 =3.3% (6.4/188.9) × 100 =3.4%
2005–06: (3.3/100.0) × 100 =3.3% (6.3/195.3) × 100 =3.2%
Module 16
Check Your Understanding
- A decline in investment spending, like a rise in investment
spending, has a multiplier effect on real GDP—the only
difference in this case is that real GDP falls instead of
rises. The fall in Ileads to an initial fall in real GDP, which
leads to a fall in disposable income (because less produc-
tion means a decrease in payments to workers), which
leads to lower consumer spending, which leads to another
fall in real GDP, and so on. So consumer spending falls as
an indirect result of the fall in investment spending. - WhenMPCis 0.5, the multiplier is equal to 1/(1 −0.5)
=1/0.5=2. When MPCis 0.8, the multiplier is equal to
1/(1−0.8)=1/0.2=5. - If you expect your future disposable income to fall, you
would like to save some of today’s disposable income to
tide you over in the future. But you cannot do this if you
cannot save. If you expect your future disposable income
to rise, you would like to spend some of tomorrow’s
higher income today. But you cannot do this if you can-
not borrow. If you cannot save or borrow, your expected
future disposable income will have no effect on your con-
sumer spending today. In fact, your MPCmust always
equal 1: you must consume all your current disposable
income today, and you will be unable to smooth your
consumption over time. - a.An unexpected increase in consumer spending will result
in a reduction in inventories as producers sell items from
their inventories to satisfy this short -term increase in
demand. This is negative unplanned inventory investment:
it reduces the value of producers’ inventories.
S-10 SOLUTIONS TO AP REVIEW QUESTIONS