Chapter 12

Questions

5. Why is it difficult to distinguish between frictional, structural, and cyclical

unemployment? Why is unemployment an economic problem? What are the
consequences of a negative GDP gap? What are the noneconomic effects of
unemployment? LO2
Answer: It is not easy to distinguish between these three types of unemployment
because they can interact. For example, a person who quits a job in search of a better one
would normally be considered frictionally unemployed. But suppose the former job then
disappears completely because the firm is in a declining industry and can no longer make
money. Our still jobless worker could now be considered structurally unemployed. And
then suppose the economy slips into a severe recession so that our worker cannot find any
job and has become cyclically unemployed. The unavoidable minimums of frictional and
structural unemployment fluctuate as the labor force structure changes. In other words,
there is no automatic label on the type of unemployment when someone is counted as
unemployed. Unemployment is an economic problem because of the opportunity cost.
Unemployment is economic waste; a labor resource that could be engaged in production
is sitting idle. The “GDP gap” is the difference between the economy’s potential GDP
and its actual GDP. The consequence of a negative GDP gap is that what is not
produced—the amount represented by the gap—is lost forever. Moreover, to the extent
that this lost production represents capital goods, the potential production for the future is
impaired. Future economic growth will be reduced. The noneconomic effects of
unemployment include a loss of skills, low morale, family disintegration, sociopolitical
unrest, increased poverty, depression, and mental illness.

7. What is the Consumer Price Index (CPI) and how is it determined each month?
How does the Bureau of Labor Statistics calculate the rate of inflation from one year to
the next? What effect does inflation have on the purchasing power of a dollar? How does
it explain differences between nominal and real interest rates? How does deflation differ
from inflation? LO3
Answer: The CPI is constructed from a “market basket” sampling of goods that
urban consumers typically purchase. Prices for goods in the market basket are collected
each month, weighted by the importance of the good in the basket (cars are more
expensive than bread, but we buy a lot more bread), and averaged to form the price level.
To calculate the rate of inflation for year 2, the BLS subtracts the CPI of year 1 from the
CPI of year 2, and then divides by the CPI of year 1 (percentage change in the price
level). Inflation reduces the purchasing power of the dollar. Facing higher prices with a
given number of dollars means that each dollar buys less than it did before. The rate of
inflation in the CPI approximates the difference between the nominal and real interest
rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest
rates are approximately 4%. Deflation means that the price level is falling, whereas with
inflation overall prices are rising. Deflation is undesirable because the falling prices mean
that incomes are also falling, which reduces spending, output, employment, and, in turn,
the price level (a downward spiral).
 8. Distinguish between demand-pull inflation and cost-push inflation. Which of
the two types is most likely to be associated with a negative GDP gap? Which with a
positive GDP gap, in which actual GDP exceeds potential GDP? What is core inflation?
Why is it calculated?
Answer: Demand-pull inflation occurs when an increase in aggregate spending is
not fully matched by an increase in aggregate output. Cost-push inflation describes prices
rising because of increases in per-unit costs of production. Cost-push inflation is most
likely to be associated with a negative GDP gap, as the rising production costs reduce
spending and output. Demand-pull inflation is more likely to occur with a positive GDP
gap, because actual GDP will exceed its potential only when aggregate spending is strong
and rising. As the economy produces above its potential, bottlenecks and more severe
resource scarcity occur, driving up prices. Core inflation measures the prices of market
basket goods that are more stable in price (excluding food and energy). It is calculated
because the more volatile food and energy prices can lead to misinterpretations of
economic performance, so policymakers prefer to examine core inflation to make
economic policy decisions.

9. Explain how an increase in your nominal income and a decrease in your real
income might occur simultaneously. Who loses from inflation? Who gains?
Answer: If a person’s nominal income increases by 10 percent while the cost of
living increases by 15 percent, then her real income has decreased because it has not kept
up with inflation. Generally, whenever the cost of living increases faster than nominal
income, real income decreases. The losers from inflation are those on incomes fixed in
nominal terms or, at least, those with incomes that do not increase as fast as the rate of
inflation. Creditors and savers also lose. The winners are borrowers who must repay
borrowed funds with dollars that are worth less than the value of the dollars borrowed.

10. Explain how “hyperinflation” might lead to a severe decline in total

output.
Answer: With extremely high inflation, it makes little sense to save. The only
sensible thing to do with money is to spend it before its value significantly falls. This act
of trying to spend as fast as possible speeds the inflationary spiral and causes people to
spend more time trying to figure out what goods are most likely to go up fastest in price.
People turn away from productive activity, because wages and salaries are not keeping up
with inflation. Instead, they spend their time speculating, transferring goods already in
existence and producing nothing. Production and investment in productive capital
decrease and unemployment soars.
 Problems
3. Suppose that the natural rate of unemployment in a particular year is 5 percent
and the actual rate of unemployment is 9 percent. Use Okun’s law to determine the size
of the GDP gap in percentage-point terms. If the potential GDP is $500 billion in that
year, how much output is being forgone because of cyclical unemployment? LO2
Answer: GDP gap = 8%; $40 billion.

Feedback: Consider the following example. Suppose that the natural rate of
unemployment in a particular year is 5 percent and the actual rate of unemployment is 9
percent. Use Okun’s law to determine the size of the GDP gap in percentage-point terms.
If the potential GDP is $500 billion in that year, how much output is being forgone
because of cyclical unemployment?

On the basis of recent estimates, Okun’s law indicates that for every 1 percentage
point by which the actual unemployment rate exceeds the natural rate, a negative
GDP gap of about 2 percent occurs.
The actual rate of unemployment exceeds the natural rate of unemployment by
4% (= 9% - 5%), which is cyclical unemployment.

Using Okun’s law, this translates into an 8% GDP gap in percentage-point terms
(= 2 x 4%).

Since potential GDP is $500 billion and we are 8% below this amount, the output
forgone is $40 billion (= 0.08 x $500 billion).

4. If the CPI was 110 last year and is 121 this year, what is this year’s rate of
inflation? In contrast, suppose that the CPI was 110 last year and is 108 this year. What is
this year’s rate of inflation? What term do economists use to describe this second
outcome? LO3
Answers: 10 percent; -1.8 percent; deflation.

Feedback: Consider the following example. If the CPI was 110 last year and is 121 this
year, what is this year’s rate of inflation? In contrast, suppose that the CPI was 110 last
year and is 108 this year. What is this year’s rate of inflation? What term do economists
use to describe this second outcome?

The inflation rate is the percentage change in the CPI over a period of time. For
the values above we have:

If the CPI was 110 last year and is 121 this year, the inflation rate was 10%
(= ((121-110)/110) x 100).

If the CPI was 110 last year and is 108 this year, the inflation rate was
approximately -1.8%
(= ((108-110)/110) x 100). This outcome is referred to as deflation by economists.
 5. How long would it take for the price level to double if inflation persisted at (a)
2, (b) 5, and (c) 10 percent per year? LO3
Answer: (a) 35 years; (b) 14 years; (c) 7 years.

Feedback: Consider the following example values. How long would it take for the price
level to double if inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year?

The “Rule of 70,” which is to divide 70 by the inflation rate, gives us the time it
takes for the price level to double.

Years to double = (70 / Inflation Rate)

Using this formula we have:

(a) The price level will double in 35 years if the inflation rate is 2% (= 70/2).

(b) The price level will double in 14 years if the inflation rate is 5% (= 70/14).

(c) The price level will double in 7 years if the inflation rate is 10% (= 70/10).

6. If your nominal income rose by 5.3 percent and the price level rose by 3.8
percent in some year, by what percentage would your real income (approximately)
increase? If your nominal income rose by 2.8 percent and your real income rose by 1.1
percent in some year, what must have been the (approximate) rate of inflation? LO3

Answer: 1.5 percent; 1.7 percent.

Feedback: Consider the following example. If your nominal income rose by 5.3 percent
and the price level rose by 3.8 percent in some year, by what percentage would your real
income (approximately) increase? If your nominal income rose by 2.8 percent and your
real income rose by 1.1 percent in some year, what must have been the (approximate) rate
of inflation?

To find the approximate percentage change in the real value of your income,
subtract the rate of inflation from the nominal percentage change in your income.
Percentage change in real income = Percentage change in nominal income -
Inflation rate
This implies the percentage change in real income is approximately 1.5% (= 5.3%
- 3.8%).

We can also rearrange the equation above as follows:

Inflation rate = Percentage change in nominal income - Percentage change in real
income
This implies the inflation rate is approximately 1.7% (= 2.8% - 1.1%) for the
second set of values.
 7. Suppose that the nominal rate of inflation is 4 percent and the inflation
premium is 2 percent. What is the real interest rate? Alternatively, assume that the real
interest rate is 1 percent and the nominal interest rate is 6 percent. What is the inflation
premium? LO3
Answers: 2 percent; 5 percent.

Feedback: Consider the following example. Suppose that the nominal rate of inflation is
4 percent and the inflation premium is 2 percent. What is the real interest rate?
Alternatively, assume that the real interest rate is 1 percent and the nominal interest rate
is 6 percent. What is the inflation premium?

To find the approximate real interest rate subtract the inflation premium from the
nominal interest rate.
Real interest rate = nominal interest rate - inflation premium

This implies the real interest rate is 2% (= 4% - 2%).

We can also rearrange the equation above as follows:

Inflation premium = nominal interest rate - real interest rate

This implies the inflation premium is 5% (= 6% - 1%).

Chapter 13
Questions

1. What are the variables (the items measured on the axes) in a graph of the (a)
consumption schedule and (b) saving schedule? Are the variables inversely (negatively)
related or are they directly (positively) related? What is the fundamental reason that the
levels of consumption and saving in the United States are each higher today than they
were a decade ago? LO1
Answer: (a) Consumption schedule: The variable on the vertical axis (y-axis) is
consumption and the variable on the horizontal axis (x-axis) is disposable income
(see Figure 27.2a).

These variables are directly (positively) related because they move in the same
direction.

(b) Saving schedule: The variable on the vertical axis (y-axis) is saving and the
variable on the horizontal axis (x-axis) is disposable income (see Figure 27.2b).

These variables are directly (positively) related because they move in the same
direction.
The level of consumption and saving in the United States is higher today than a
decade ago because real GDP and income are higher.
 2. Precisely how do the MPC and the APC differ? How does the MPC differ from
the MPS? Why must the sum of MPC and the MPS equal 1? LO1
Answer: MPC refers to changes in spending and income at the margin. Here we
compare a change in consumer spending to a change in income: MPC = change in
C / change in Y. APC is an average whereby total spending on consumption (C) is
compared to total income (Y): APC = C/Y.
When your income changes there are only two possible options regarding what to
do with it: You either spend it or you save it. MPC is the fraction of the change
in income spent; therefore, the fraction not spent must be saved and this is the
MPS. The change in the dollars spent or saved will appear in the numerator and
together they must add to the total change in income. Since the denominator is
the total change in income, the sum of the MPC and MPS is one.

3. In what direction will each of the following occurrences shift the consumption
and saving schedules, other things equal? LO2
a. A large decrease in real estate values, including private homes.
b. A sharp, sustained increase in stock prices.
c. A 5-year increase in the minimum age for collecting Social Security benefits.
d. An economy-wide expectation that a recession is over and that a robust expansion will
occur.
e. A substantial increase in household borrowing to finance auto purchases.
Answer: (a) The consumption schedule will shift downward and the saving
schedule will shift upward given the decrease in wealth.
(b) The consumption schedule will shift upward and the saving schedule will shift
downward given the increase in wealth.
(c) The consumption schedule will likely shift upward and the saving schedule
will likely shift downward given that individuals will need to work 5 more years
before retiring. There is less need to save for retirement.
(d) The consumption schedule will shift upward and the saving schedule will shift
downward because individuals expect to be earning higher income in the future.
(e) The consumption schedule will shift upward and the saving schedule will shift
downward as individuals borrow (decrease saving) and purchase the automobiles
(increase consumption).

4. Why does a downshift of the consumption schedule typically involve an equal

upshift of the saving schedule? What is the exception to this relationship? LO2
Answer: If, by definition, all that you can do with your income is use it for
consumption or saving, then if you consume less out of any given income, you
will necessarily save more. This being so, when your consumption schedule
shifts downward (meaning you are consuming less out of any given income), your
saving schedule shifts upward (meaning you are saving more out of any given
income).
The exception is a change in personal taxes. When these change, your disposable
income changes, and, therefore, your consumption and saving both change in the
 same direction and opposite to the change in taxes. If your MPC, say, is 0.9, then
your MPS is 0.1. Now, if your taxes increase by $100, your consumption will
decrease by $90 and your saving will decrease by $10.

5. Why will a reduction in the real interest rate increase investment spending,
other things equal? LO3
Answer: Firms will only make an investment purchase if the expected return is
greater than or equal to real interest rate at which it can borrow.
The logic is as follows. If you borrow a $100 at an interest rate of 10%, then at the
end of the year you will owe $110.
Now, if you can earn a rate of return of 20% on the borrowed $100, then you will
have $120 from your investment at the end of the year. You pay off the $110 loan
and keep $10. This is a good investment.
However, if you can earn a rate of return of 5% on the borrowed $100, then you
will have $105 from your investment at the end of the year. You pay off the $110
loan and lose $5. This is a bad investment.
Using this logic, a reduction in the real interest rate will make previously
unprofitable investments profitable. Thus, other things equal, this will increase
investment.
For example, if the real interest rate fell from 10% to 3% it would be a good
investment to borrow at 5% and now, where it wasn't before when the real interest
rate was 10%.

6. In what direction will each of the following occurrences shift the investment
demand curve, other things equal? LO4
a. An increase in unused production capacity occurs.
b. Business taxes decline.
c. The costs of acquiring equipment fall.
d. Widespread pessimism arises about future business conditions and sales revenues.
e. A major new technological breakthrough creates prospects for a wide range of
profitable new products.
Answer: (a) This will decrease investment demand causing the investment curve
to shift to the left. The increase in unused capacity reduces the need (expected
return) for capital.
(b) This will increase investment demand causing the investment curve to shift to
the right. The decrease in business taxes increase after-tax expected returns
(which determines investment decisions).
(c) This will increase investment demand causing the investment curve to shift to
the right. The expected return increases due to the declining cost.
(d) This will decrease investment demand causing the investment curve to shift to
the left. Widespread pessimism about future business conditions and sales
revenues reduces expected returns.
(e) This will increase investment demand causing the investment curve to shift to
the right. The major new technological breakthrough increases expected returns.
 7. How is it possible for investment spending to increase even in a period in
which the real interest rate rises? LO4
Answer: As long as expected rates of return rise faster than real interest rates,
investment spending may increase. This is most likely to occur during periods of
economic expansion.

8. Why is investment spending unstable? LO4

Answer: Investment is unstable because, unlike most consumption, it can be
put off. In good times, with demand strong and rising, businesses will bring in
more machines and replace old ones. In times of economic downturn, no new
machines will be ordered. A firm can continue for years with, say, a tenth of the
investment it was carrying out in the boom. Very few families could cut their
consumption so drastically.
Also, new business ideas and the innovations that spring from them do not come
at a constant rate. This is another reason for the irregularity of investment.
Profits and the expectations of profits vary. Since profits, in the absence of easy
access to borrowed money, are essential for investment and since, moreover, the
object of investment is to make a profit, investment, too, must vary.

Problems

1. Refer to the incomplete table below. LO1

a. Fill in the missing numbers in the table.

b. What is the break-even level of income in the table? What is the term that economists
use for the saving situation shown at the $240 level of income?
c. For each of the following items indicate whether the value in the table is either
constant or variable as income changes: the MPS, the APC, the MPC, the APS.

Answers: (a) data in the completed table; (b) $260, dissaving; (c) constant, variable,
constant, variable.
 Feedback: Consider the following example. Refer to the nearby incomplete
table.

Part a:
Fill in the missing numbers in the table.
Level of
Output
and
Income Consumption Saving APC APS MPC MPS
(GDP=DI)
$240 $244 -$4 1.0167 -0.0167 0.8 0.2
260 $260 0 1 0 0.8 0.2
280 $276 4 0.9857 0.0143 0.8 0.2
300 $292 8 0.9733 0.0267 0.8 0.2
320 $308 12 0.9625 0.0375 0.8 0.2
340 $324 16 0.9529 0.0471 0.8 0.2
360 $340 20 0.9444 0.0556 0.8 0.2
380 $356 24 0.9368 0.0632 0.8 0.2
400 $372 28 0.93 0.07 0.8 0.2

To find the level of consumption (column 2):

Consumption = Income - Saving

Example: at Income $300 Consumption = $300 - $8 = $292

To find the Average Propensity to Consume (APC) (column 4):

APC = Consumption/Income
 Example: at Income $300 APC = $292/$300 = 0.9733

To find the Average Propensity to Save (APS) (column 5):

APS = Saving/Income

Example: at Income $300 APS = $8/$300 = 0.0267

To find the Marginal Propensity to Consume (MPC) (column 6):

MPC = Δ Consumption/Δ Income

Example: at Income $300 (from $280) MPC = $16/$20 = 0.8

To find the Marginal Propensity to Save (MPS) (column 7):

MPS= Δ Saving/Δ Income

Example: at Income $300 (from $280) MPS = $4/$20 = 0.2

Part b:
What is the break-even level of income in the table? What is the term that
economists use for the saving situation shown at the $240 level of income?
Break-even level of income is where saving equals zero (consumption equals
income). Thus, the break-even level of income is $260.
At the level of income $240 saving is negative. Economists refer to this as
dissaving.

Part c:
For each of the following items indicate whether the value in the table is either
constant or variable as income changes: the MPS, the APC, the MPC, the APS.

MPS: Constant (does not change with income)

APC: Variable (changes with income)

MPC: Constant (does not change with income)

APS: Variable (changes with income)

 2. Suppose that disposable income, consumption, and saving in some country are
$200 billion, $150 billion, and $50 billion, respectively. Next, assume that disposable
income increases by $20 billion, consumption rises by $18 billion and saving goes up by
$2 billion. What is the economy’s MPC? Its MPS? What was the APC before the increase
in disposable income? After the increase? LO1
Answers: .9; .1; .75; .764.

Feedback: Consider the following example. Suppose that disposable income,

consumption, and saving in some country are $200 billion, $150 billion, and $50
billion, respectively. Next, assume that disposable income increases by $20
billion, consumption rises by $18 billion and saving goes up by $2 billion. What
is the economy’s MPC? Its MPS? What was the APC before the increase in
disposable income? After the increase?

What is the economy’s MPC?

To find the Marginal Propensity to Consume (MPC): MPC = Δ Consumption/Δ

Income

MPC = $18/$20 =0.9

What is the economy’s MPS?

To find the Marginal Propensity to Save (MPS): MPC = Δ Saving/Δ Income

MPS = $2/$20 =0.1

What was the APC before the increase in disposable income?

To find the Average Propensity to Consume (APC): APC = Consumption/Income

APC = $150/$200 = 0.75

What was the APC after the increase in disposable income?
Disposable Income after the change equals $220 (=$200 +$20)

Consumption after the change equals $168 (= $150 +$18). The MPC is 0.9, so
consumption increases by $18 given the increase in disposable income of $20.

APC = $168/$220 = 0.7636

 5. Use your completed table for problem 1 to solve this problem. Suppose the
wealth effect is such that $10 changes in wealth produce $1 changes in consumption at
each level of income. If real estate prices tumble such that wealth declines by $80, what
will be the new level of consumption at the $340 billion level of disposable income? The
new level of saving? LO2
Answers: $316; $24.

Feedback: Consider the following example. Use your completed table for
problem 1 to solve this problem. Suppose the wealth effect is such that $10
changes in wealth produce $1 changes in consumption at each level of income. If
real estate prices tumble such that wealth declines by $80, what will be the new
level of consumption at the $340 billion level of disposable income? The new
level of saving?

TABLE FROM PROBLEM 1

Level of
Output
and
Income Consumption Saving APC APS MPC MPS
(GDP=DI)
$240 $244 -$4 1.0167 -0.0167 0.8 0.2
260 $260 0 1 0 0.8 0.2
280 $276 4 0.9857 0.0143 0.8 0.2
300 $292 8 0.9733 0.0267 0.8 0.2
320 $308 12 0.9625 0.0375 0.8 0.2
340 $324 16 0.9529 0.0471 0.8 0.2
360 $340 20 0.9444 0.0556 0.8 0.2
380 $356 24 0.9368 0.0632 0.8 0.2
400 $372 28 0.93 0.07 0.8 0.2

If real estate prices tumble such that wealth declines by $80 and the wealth effect
is such that a $10 change in wealth produce a $1 change in consumption at each
level of income, then consumption will fall by $8 at every level of income (= 0.1
x $80).

This implies consumption equals $316 at the income level of $340. Consumption
was originally $324 at this income level and the decline in wealth results in a fall
in consumption of $8.

To find the new level of savings after the decline in wealth we subtract the NEW
level of consumption (=$316) from disposable income (=$340), which equals $24
(= $340 - $316). The household increases savings to offset the decline in wealth.
 6. Suppose a handbill publisher can buy a new duplicating machine for $500 and
the duplicator has a 1-year life. The machine is expected to contribute $550 to the year’s
net revenue. What is the expected rate of return? If the real interest rate at which funds
can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest
in the machine? Will it invest in the machine if the real interest rate is 9 percent? If it is
11 percent? LO3
Answers: 10 percent; yes; yes; no.

Feedback: Consider the following example. Suppose a handbill publisher can

buy a new duplicating machine for $500 and the duplicator has a 1-year life. The
machine is expected to contribute $550 to the year’s net revenue. What is the
expected rate of return? If the real interest rate at which funds can be borrowed to
purchase the machine is 8 percent, will the publisher choose to invest in the
machine? Will it invest in the machine if the real interest rate is 9 percent? If it is
11 percent?

The expected rate of return equals the expected net revenue less cost divided by
the cost of the machine.

Expected return = (net revenue - cost)/cost = ($550 - $500)/$500 =

$50/$500 = 0.1

In percentage terms 10% (= 100 x 0.1).

The firm will only make this purchase if the expected return is greater than or
equal to interest rate at which it can borrow.

The logic is as follows. If you borrow a $100 at an interest rate of 10%, then at the
end of the year you will owe $110.

Now, if you can earn a rate of return of 20% on the borrowed $100, then you will
have $120 from your investment at the end of the year. You pay off the $110 loan
and keep $10. This is a good investment.

However, if you can earn a rate of return of 5% on the borrowed $100, then you
will have $105 from your investment at the end of the year. You pay off the $110
loan and lose $5. This is a bad investment.

Back to our problem: So, if the real interest rate at which funds can be borrowed
to purchase the machine is 8 percent, will the publisher choose to invest in the
machine? Yes, 10% is greater than 8%

Will it invest in the machine if the real interest rate is 9 percent? Yes, 10% is
greater than 9%. If it is 11 percent? No, 10% is less than 11%.
 7. Assume there are no investment projects in the economy that yield an expected
rate of return of 25 percent or more. But suppose there are $10 billion of investment
projects yielding expected returns of between 20 and 25 percent; another $10 billion
yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and
so forth. Cumulate these data and present them graphically, putting the expected rate of
return (and the real interest rate) on the vertical axis and the amount of investment on the
horizontal axis. What will be the equilibrium level of aggregate investment if the real
interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent? LO3

Answer:

(a) $20 billion

(b) $30 billion
(c) $40 billion

Feedback: Consider the following example. Assume there are no investment

projects in the economy that yield an expected rate of return of 25 percent or
more. But suppose there are $10 billion of investment projects yielding expected
returns of between 20 and 25 percent; another $10 billion yielding between 15
and 20 percent; another $10 billion between 10 and 15 percent; and so forth.
Cumulate these data and present them graphically, putting the expected rate of
return (and the real interest rate) on the vertical axis and the amount of investment
on the horizontal axis. What will be the equilibrium level of aggregate investment
if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent?

The firm will only make an investment if the expected return is greater than or
equal to interest rate at which it can borrow.

At an interest rate of 25% investment is zero (no project yields an expected rate of
return of 25% or more)

At an interest rate of 20% investment is $10 billion (these are projects with
expected rates of return between 20% and 24.99%)
 At an interest rate of 15% investment is $20 billion (these are projects with
expected rates of return between 15% and 24.99%. There are $10 billion between
15% and 19.99% and $10 billion between 20% and 24.99%. Investment is
cumulative)

At an interest rate of 10% investment is $30 billion (logic above applies)

At an interest rate of 5% investment is $40 billion (logic above applies)

At an interest rate of 0% investment is $50 billion (logic above applies)

See the graph below.

(a) If the rate at which firms can borrow is 15% (real interest rate), then aggregate
investment is $20 billion.
(b) If the rate at which firms can borrow is 10% (real interest rate), then aggregate
investment is $30 billion.
(c) If the rate at which firms can borrow is 5% (real interest rate), then aggregate
investment is $40 billion.

8. Refer to the table in Figure 27.5 in the book and suppose that the real interest
rate is 6 percent. Next, assume that some factor changes such that that the expected rate
of return declines by 2 percentage points at each prospective level of investment.
Assuming no change in the real interest rate, by how much and in what direction will
investment change? Which of the following might cause this change: (a) a decision to
increase inventories; (b) an increase in excess production capacity? LO4
Answers: $5 billion decrease; (b).

Feedback: Consider the following example. Refer to the table below and suppose
that the real interest rate is 6 percent. Next, assume that some factor changes such
that that the expected rate of return declines by 2 percentage points at each
prospective level of investment. Assuming no change in the real interest rate, by
how much and in what direction will investment change? Which of the following
might cause this change: (a) a decision to increase inventories; (b) an increase in
excess production capacity?

Since the expected rate of return has fallen by 2 percentage points investment at
each real interest rate will decrease. The investment schedule will shift to the left.

The next question is by how much?

To answer this question we use the following logic.

Initially investment at the real interest rate of 6% is $25 billion (see figure 27.5
above).

Since the expected rate of return has fallen by 2 percentage points, the return on
the last dollar invested of the $25 billion (the $25 billionth dollar) has fallen to
4%. The real interest has not changed, it is still at 6% so this investment is no
longer made.

This is true for every investment dollar beyond $20 billion because the return has
fallen by 2 percentage points and the return is now below 6% (originally below
8%).

The marginal return on the $20 billionth (dollar) is 6% because the original return
was 8%. All of the investment dollars before the $20 billionth (dollar) also earns a
return greater than 6%. So investment at the 6% real interest rate is now $20
billion.
The investment schedule shifts in by $5 billion at every real interest rate.

Which of the following might cause this change: (a) a decision to increase
inventories; (b) an increase in excess production capacity?

The answer is (a). An increase in excess production capacity will reduce

investment demand because each new machine does not add as much to output
(firm already has significant excess capacity).