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Chapter 26: Problem 8

Explain how each of the following actions will affect the level of planned investment spending and unplanned inventory investment. Assume the economy is initially in income-expenditure equilibrium. a. The Federal Reserve raises the interest rate. b. There is a rise in the expected growth rate of real GDP. c. A sizable inflow of foreign funds into the country lowers the interest rate.

Short Answer

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a. The Federal Reserve raises the interest rate. b. There is a rise in the expected growth rate of real GDP. c. A sizable inflow of foreign funds into the country lowers the interest rate. Answer: a. A rise in the interest rate leads to a decrease in both planned investment spending and unplanned inventory investment. b. An increase in the expected growth rate of real GDP results in an increase in planned investment spending and potentially higher unplanned inventory investment. c. A sizable inflow of foreign funds lowering the interest rate causes an increase in both planned investment spending and unplanned inventory investment.

Step by step solution

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a. The Federal Reserve raises the interest rate

When the Federal Reserve raises interest rates, borrowing becomes more expensive. As a result, firms are less likely to obtain loans to finance new investments. This leads to a decrease in planned investment spending. Additionally, higher interest rates make it more expensive for firms to hold inventory, so firms will try to minimize their unplanned inventory investment. In this case, unplanned inventory investment would also decrease.
02

b. There is a rise in the expected growth rate of real GDP

When there is an expected increase in the growth rate of real GDP, firms are more optimistic about future demand for their products. Therefore, they are more likely to invest in new capital and inventory to meet the expected increase in demand. This implies an increase in planned investment spending. However, since firms are planning for an increase in demand, they may increase their inventory levels in anticipation. This could result in a higher level of unplanned inventory investment.
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c. A sizable inflow of foreign funds into the country lowers the interest rate

When foreign funds flow into the country, the overall supply of funds available for lending increases. This results in lower interest rates, making borrowing more affordable for firms. As a result, planned investment spending is likely to increase. Regarding unplanned inventory investment, lower interest rates make it cheaper for firms to hold inventory. Therefore, firms may be more willing to hold a higher level of inventory, which could result in an increase in unplanned inventory investment.

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Most popular questions from this chapter

Assuming that the aggregate price level is constant, the interest rate is fixed, and there are no taxes and no foreign trade, what will be the change in GDP if the following events occur? a. There is an autonomous increase in consumer spending of \(\$ 25\) billion; the marginal propensity to consume is \(2 / 3\). b. Firms reduce investment spending by \(\$ 40\) billion; the marginal propensity to consume is 0.8 . c. The government increases its purchases of military equipment by \(\$ 60\) billion; the marginal propensity to consume is 0.6

The Bureau of Economic Analysis reported that, in real terms, overall consumer spending increased by \(\$ 66.2\) billion during the second quarter of \(2014 .\) a. If the marginal propensity to consume is \(0.52,\) by how much will real GDP change in response? b. If there are no other changes to autonomous spending other than the increase in consumer spending in part a, and unplanned inventory investment, \(I_{\text {Unplanned }}\), decreased by \(\$ 50\) billion, what is the change in real GDP? c. GDP at the end of the first quarter in 2014 was \(\$ 16,014.1\) billion. If GDP were to increase by the amount calculated in part b, what would be the percent increase in GDP?

Although the United States is one of the richest nations in the world, it is also the world's largest debtor nation. We often hear that the problem is the nation's low savings rate. Suppose policy makers attempt to rectify this by encouraging greater savings in the economy. What effect will their successful attempts have on real GDP?

An economy has a marginal propensity to consume of \(0.5,\) and \(Y^{*},\) income- expenditure equilibrium GDP, equals \(\$ 500\) billion. Given an autonomous increase in planned investment of \(\$ 10\) billion, show the rounds of increased spending that take place by completing the accompanying table. The first and second rows are filled in for you. In the first row, the increase of planned investment spending of \(\$ 10\) billion raises real GDP and \(Y D\) by \(\$ 10\) billion, leading to an increase in consumer spending of \(\$ 5\) billion \((M P C \times\) change in disposable income) in row \(2,\) raising real GDP and \(Y D\) by a further \(\$ 5\) billion. a. What is the total change in real GDP after the 10 rounds? What is the value of the multiplier? What would you expect the total change in \(Y^{*}\) to be based on the multiplier formula? How do your answers to the first and third questions compare? b. Redo the table starting from round 2 , assuming the marginal propensity to consume is \(0.75 .\) What is the total change in real GDP after 10 rounds? What is the value of the multiplier? As the marginal propensity to consume increases, what happens to the value of the multiplier?

In an economy with no government and no foreign sectors, autonomous consumer spending is \(\$ 250\) billion, planned investment spending is \(\$ 350\) billion, and the marginal propensity to consume is \(2 / 3\). a. Plot the aggregate consumption function and planned aggregate spending. b. What is unplanned inventory investment when real GDP equals \(\$ 600\) billion? c. What is \(Y^{*}\), income-expenditure equilibrium GDP? d. What is the value of the multiplier? e. If planned investment spending rises to \(\$ 450\) billion, what will be the new \(Y^{*}\) ?
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