Class Exercise 1
Class Exercise 1
Place each of the following transactions in one of the four components of expenditure: consumption,
investment, government purchases, and net exports.
a.
b.
c.
d.
e.
government purchases
Investment
net exports
consumption
investment
2. Abby consumes only apples. In year 1, red apples cost $1 each, green apples cost $2 each, and Abby
buys 10 red apples. In year 2, red apples cost $2, green apples cost $1, and Abby buys 10 green apples.
a. Compute a consumer price index for apples for each year. Assume that year 1 is the base year in
which the consumer basket is fixed. How does your index change from year 1 to year 2?
CPI1 = ($1 x 10 red apples) + ($2 x 0 green apples) x 100 = 100
($1 x 10 red apples) + ($2 x 0 green apples)
CPI2 = ($2 x 10 red apples ) + ($1 x 0 green apples) x 100 = 200
($1 x 10 red apples) + ($2 x 0 green apples)
CPI doubles from year 1 to year 2.
b.
Compute Abbys nominal spending on apples in each year. How does it change from year 1 to year 2?
Nominal GDP1 = ($1 x 10 red apples) + ($2 x 0 green apples) = 10
Nominal GDP2 = ($2 x 0 red apples ) + ($1 x 10 green apples) = 10
Abbys nominal spending does not change from year 1 to year 2.
3. The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6, what
happens to the following? Do they rise or fall? By what amounts?
a. Public saving rises by $100 billion.
b. Private saving will fall because consumers will have to pay more taxes, thus having less disposable
income to use for consumption.
c. National saving will increase - this is due to the increase in Public Savings caused by the
government's policy to raise taxes.
d. Investment will rise.
Use excel file uploaded in groups for numerical example.
A note on answering 3:
Private Saving = Y T C
= Y T [a + b(Y-T)]
= Y T a bY + bT
= (1-b) (Y-T) a
National Saving = Y C G
= Y [a + b(Y-T)] G
= Y a bY + bT G
= (1-b)Y + bT G a