An email exchange with a student about coursebook problems.
Can you explain the following problems from the coursebook:
>>Chapter 10
>> 2b
>
>Net Exports means (X - M), exports minus imports. Imports depend on real GDP. So the leakage out of the circular flow is greater each round; the expenditure multiplier is one divided by [one minus the marginal propensity to spend on domestically produced output], and that "marginal propensity to spend on domestically produced output" is smaller when there are imports that depend on income. So you are dividing one by a larger number (one minus a smaller one) when there is foreign trade, so the multiplier is smaller.
>
>> 3
>a. Marginal propensity to consume (MPC) is [change in consumption]/[change in income], i.e. with these numbers 1,200/1000 = 1.2.
>b. 100 x 1.2 = 120. Where does the extra purchasing power come from? Presumably from dissaving -- i.e. reducing assets.
>c. Round 1: extra income $100 --> extra consumption $120
>round 2: extra income $120 --> extra consumption $144
>round 3: extra income $144 --> extra consumption $172.8
>
>d. This is not a convergent series -- it explodes. There would be no equilibrium. It is kind of a silly example, but the underlying point is that the process cannot be sustained -- if when income increases, spending increases by more [presumably because people spend some of their accumulated saving as well as their extra income], that cannot go on for ever because eventually they have to run out of accumulated saving (and credit). Normally, we assume that the MPC<1 for precisely this reason.
>
>> 7
>current GDP = $500 trn, full employment GDP = $600 trn.
>MPC = 4/5 = 0.8
>How much does I need to increase to make equilibrium GDP the full employment level?
>
>Multiplier = 1/(1 - MPC) = 1/0.2 = 5
>Change in GDP needed is + $100 trn.
>
>Therefore change needed in I is $100 trn/5 = +$20 trn.
>
>If I increases, that increases GDP, income, and therefore consumption spending; the increase in consumption spending also increases GDP, income, and therefore consumption spending again, and so on round by round. The multiplier is the ratio of the final change in equilibrium GDP to the change in autonomous spending that started the change. This can happen because we started with equilibrium GDP below full employment level, so there was spare capacity and the increased spending produced more real output, not inflation.
>
>I can't draw the diagrams in an email.
>
>>Chapter 12
>
>> 2
>Money supply is $600 bn and the reserve requirement is 20%. That means each $1 of reserves can support at most $5 of checkable deposits.
>$5 bn is withdrawn from a New York account and not redeposited in the system (e.g. it is shifted to a Swiss bank account or used to buy gold). Then reserves of the banking system have gone down by $5 bn, so if there are at no stage any excess reserves and ignoring currency, the money supply would have to go down by 5 x $5bn = $25 bn, so the new money supply would be $600 - 25 = $575 bn.
>
>> 6 in first multiple choice section
>Fed sells $5 million of US securities to the public. The public pay for them, and by so doing reduce the reserves of commercial banks by $5 million (money is Fed IOUs, so when the public return those IOUs, they disappear and the commercial bank reserves have gone down by that amount). If the reserve requirement is 10%, each $1 of reserves can support at most $10 of checkable deposits. So, with no leakages and no excess reserves, after a period of time the checkable deposits and thus the money supply must decrease by 10 x $5 million equals $50 million, b.
>