Deck 4: Consumption, Saving, and Investment

Question 1

The tendency to reduce current consumption and increase future consumption as the real interest rate increases is called

A) the substitution effect of the real interest rate on saving.
B) the income effect of the real interest rate on saving.
C) the net effect of the real interest rate on saving.
D) the substitution effect of the real interest rate on investment.

Answer 1

A

Question 2

The Canadian consumption function is given by C = 50 + 0.75 Y. This implies that

A) Canadians spend 75 percent of their income on average.
B) each Canadian spends 75 percent of her/his income.
C) Canadians on average spend 75 cents out of each additional dollar earned.
D) Canadian spend 50 dollars of their income on average.

Answer 2

C

Question 3

Three factors that cause interest rates among different financial instruments to vary are

A) default risk, expected inflation, and taxability.
B) default risk, current inflation, and taxability.
C) default risk, maturity, and taxability.
D) default risk, expected inflation, and maturity.

Answer 3

C

Question 4

The housing price in Canada nearly doubled in the period 1995-2006. This implies that

A) Canadian homeowners income has increased, leading to more consumption.
B) Canadian homeowners wealth has increased, leading to more consumption.
C) Canadian homeowners wealth has decreased, leading to lower consumption.
D) Canadian homeowners income has decreased, leading to less consumption.

Question 5

The nominal interest rate is 10%, the expected inflation rate is 5%, and the combined state-federal tax is 35%.The expected real after-tax rate of return is

A) 1.50%.
B) 3.25%.
C) 5.00%.
D) 6.50%.

Question 6

If you lend money to the government by buying a one-year Treasury bill, your interest rate is 4%, but if you lend money to XYZ corporation by buying a one-year XYZ bond, you can earn 7%. What is the main reason for this difference in interest rates?

A) higher tax rate on the XYZ bond
B) higher inflation on the XYZ bond
C) higher default risk on the XYZ bond
D) higher expected real after-tax rate of return on the XYZ bond

Question 7

An increase in housing prices in Canada will likely have stronger effect on the aggregate consumption than a similar increase in the stock prices, because

A) there are more Canadian stockholders than Canadian homeowners.
B) stock prices are far more volatile than the housing prices.
C) changes in stock prices are seen as permanent changes in wealth.
D) housing prices are more volatile than the stock prices.

Question 8

With a nominal interest rate of 8%, an expected inflation rate of 3%, and interest income taxed at a 25% rate, what is the expected after-tax real interest rate?

A) 5%
B) 3.75%
C) 3%
D) 1%

Question 9

A temporary increase in government purchases, given the level of output, will lead to

A) a higher desired consumption and a higher desired national saving.
B) a lower desired consumption and a lower desired national saving.
C) a higher desired consumption and a lower desired national saving.
D) a lower desired consumption and a higher desired national saving.

Question 10

Franco the economist uses data for Canada to estimate a Keynesian consumption function: C^d = 0.46 + 0.92Y
In this equation, what is the marginal propensity to consume?

A) 0.46
B) 0.50
C) 0.92
D) 1.38

Question 11

An increase in expected future output while holding today's output constant would

A) increase today's desired consumption and increase desired national saving.
B) increase today's desired consumption and decrease desired national saving.
C) decrease today's desired consumption and increase desired national saving.
D) decrease today's desired consumption and decrease desired national saving.

Question 12

Desired national saving would unambiguously increase if there were

A) an increase in current output and expected future output.
B) an increase in expected future output and government purchases.
C) an increase in expected future output and the expected real interest rate.
D) a fall in both government purchases and expected future output.

Question 13

The effect of an increase in current consumption that results when a higher real interest rate makes a consumer richer is called

A) the substitution effect of the real interest rate on saving.
B) the income effect of the real interest rate on saving.
C) the net effect of the real interest rate on saving.
D) the substitution effect of the real interest rate on consumption.

Question 14

The effect of changes in wealth on consumers' spending is

A) significantly higher if the change in wealth arises from the housing rather than that arises from stock market.
B) significantly lower if the change in wealth arises from the housing rather than that arises from stock market.
C) significantly higher if the change in wealth arises from saving rather than that arises from the housing.
D) not dependent on the type of wealth.

Question 15

Aunt Agatha has just left her nephew $5000. The most likely response is for her nephew to

A) increase current consumption, but not future consumption.
B) decrease current consumption, but increase future consumption.
C) increase future consumption, but not current consumption.
D) increase both current consumption and future consumption.

Question 16

The stock market just crashed; the Dow Jones Industrial Average fell by 750 points. You would expect the effect on aggregate consumption to be the largest if which of the following facts were true?

A) The crash had been preceded by a large run-up in the price of stocks.
B) Most stocks were owned by insurance companies.
C) Most stocks were owned by pension funds that invested in the market.
D) Many individuals had invested in the stock market immediately prior to the crash.

Question 17

When a person gets an increase in current income, what is likely to happen to consumption and saving?

A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.

Question 18

When a person receives an increase in wealth, what is likely to happen to consumption and saving?

A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.

Question 19

If the aggregate consumption function is C = 20 + 0.75 Y, the aggregate saving function will be

A) S = 20 -0.75Y
B) S = 20 +0.75 Y
C) S = -20 + 0.75 Y
D) S = -20 +0.25 Y

Question 20

An increase in expected real interest rates would probably cause desired national saving to rise because

A) less must be saved to reach a given saving target.
B) the increased return makes saving more attractive.
C) the government would respond by increasing expenditures.
D) current interest rates would fall in response to higher expected real interest rates in the future.

Question 21

Which of the factors listed below might cause the Ricardian equivalence proposition to be violated?

A) There may be international capital inflow and outflows.
B) Consumers may not understand that increased government borrowing today is likely to lead to higher future taxes.
C) There may be constraints on the level of government spending.
D) There may be constraints on the level of government taxation.

Question 22

If the government cuts taxes today, issuing debt today and repaying the debt plus interest next year, a rational taxpayer will

A) spend the full amount of the tax cut today and reduce consumption next year.
B) increase consumption today, before taxes go up next year.
C) increase saving today, leaving consumption unchanged.
D) leave a smaller gross bequest to her or his heirs.

Question 23

When firms carry out new investment, the user cost of capital

A) increases as the amount of capital increases.
B) decreases as the amount of capital increases.
C) first decreases, then increases as the amount of capital increases.
D) remains constant as the amount of capital increases.

Question 24

The Ricardian equivalence proposition suggests that a government deficit caused by a tax cut

A) causes inflation.
B) causes a current account deficit.
C) raises interest rates.
D) doesn't affect consumption.

Question 25

The Ricardian equivalence proposition says that

A) a budget deficit caused entirely by a current tax cut has no effect on the economy.
B) a budget deficit caused entirely by an increase in government purchases has no effect on the economy.
C) any budget deficit generated by the government has no effect on the economy.
D) an increase in government spending accompanied by an equivalent increase in taxes has no effect on the economy.

Question 26

The "q theory of investment," or "Tobin's q" states that

A) a rise in the stock market would lead firms to increase their rate of capital investment.
B) a fall in the stock market would lead firms to increase their rate of capital investment.
C) a rise in the stock market would lead firms to decrease their rate of capital investment.
D) there is no relationship between the stock price changes and the capital investment.

Question 27

Which of the following machines has the lowest user cost? Machine A costs $15,000 and depreciates at a 25% rate, machine B costs $10,000 and depreciates at a 20% rate, machine C costs $10,000 and depreciates at a 10% rate, and machine D costs $17,000 and depreciates at an 11% rate. The expected real interest rate is 0%.

A) machine A
B) machine B
C) machine C
D) machine D

Question 28

Which of the following machines has the lowest user cost? Machine A costs $15,000 and depreciates at a 25% rate, machine B costs $10,000 and depreciates at a 20% rate, machine C costs $20,000 and depreciates at a 10% rate, and machine D costs $17,000 and depreciates at an 11% rate. The expected real interest rate is 5%.

A) machine A
B) machine B
C) machine C
D) machine D

Question 29

A technological improvement will

A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as an increase in corporate taxes.

Question 30

A decrease in the real interest rate will

A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as an increase in corporate taxes.

Question 31

You are trying to figure out how much capacity to add to your factory. You will increase capacity as long as

A) the expected marginal product of capital is positive.
B) the expected marginal product of capital is greater than or equal to the marginal product of capital.
C) the expected marginal product of capital is greater than or equal to the expected marginal product of labour.
D) the expected marginal product of capital is greater than or equal to the user cost of capital.

Question 32

Suppose your company is in equilibrium, with its capital stock at its desired level. A permanent increase in the depreciation rate now has what effect on your desired capital stock?

A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the user cost of capital is now lower
D) lowers it, because the user cost of capital is now higher

Question 33

According to Tobin's q,

A) when the stock market is high, firms do not change their investment.
B) when the stock market is low, firms increase their investment.
C) when the stock market is high, firms increase their investment.
D) firms' decisions on investment do not depend on the stock market.

Question 34

Suppose your company is in equilibrium, with its capital stock at its desired level. A permanent decline in the real interest rate now has what effect on your desired capital stock?

A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the user cost of capital is now lower
D) lowers it, because the user cost of capital is now higher

Question 35

The user cost of capital is given by the following formula, where P_K is the real price of capital goods, d is the depreciation rate, and r is the expected real interest rate:

A) uc = (r + d)/P_K
B) uc = P_K/(r + d)
C) uc = dP_K/r
D) uc = (r + d)P_K

Question 36

A temporary increase in government purchases, when total output held constant, would

A) reduce desired consumption but would increase desired national saving.
B) increase desired consumption but would reduce desired national saving.
C) increase both desired consumption and desired national saving.
D) reduce both desired consumption and desired national saving.

Question 37

Calculate the user cost of capital of a machine that costs $5,000 and depreciates at a 25% rate, when the interest rate is 5%.

A) $150
B) $500
C) $1500
D) $5000

Question 38

The lesson to be learned from the Ricardian equivalence proposition is that

A) only government budget deficits generated by tax changes affect the macroeconomy.
B) government budget deficits do not affect the macroeconomy.
C) it is impossible for the government to actually reduce taxes.
D) the basic measure of the cost of government is the real resources that the government uses.

Question 39

You have just purchased a new VCR to show videos to your customers. The VCR cost $500, and you depreciate the machine at a rate of 25% each year. You can borrow money from the bank at 10%, or receive 6% for depositing money at the bank. The expected inflation rate in the coming year is 5%. You used the company's own funds to purchase the VCR. The firm's user cost of capital for the first year is

A) $130.
B) $150.
C) $155.
D) $175.

Question 40

You have just purchased a new VCR to show videos to your customers. The VCR cost $500, and you depreciate the machine at a rate of 25% each year. You can borrow money from the bank at 10%, or receive 6% for depositing money at the bank. The expected inflation rate in the coming year is 5%. You borrowed money from the bank to purchase the VCR. The firm's user cost of capital for the first year is

A) $130.
B) $150.
C) $155.
D) $175.

Question 41

An economy has full-employment output of 5000. Government purchases are 1000. Desired consumption and desired investment are given by C^d = 3000 - 2000r + .10Y
I^d = 1000 - 4000r
Where Y is output and r is the real interest rate. The real interest rate that clears the good market is equal to

A) 1.25%.
B) 2.50%.
C) 8.33%.
D) 25.00%.

Question 42

An increase in the expected real interest rate tends to

A) raise desired savings only.
B) raise desired investment only.
C) raise both desired savings and desired investment.
D) raise desired savings, but lower desired investment.

Question 43

What key change in 1975-87 led to a faster growth rate of equipment relative to structures?

A) a change in relative tax rates
B) a change in relative depreciation rates
C) a change in relative prices
D) a change in relative marginal productivity

Question 44

The effective tax rate is

A) a single measure of tax owed by a firm.
B) a single measure of the tax credit on investment.
C) a single measure of how much tax a firm pays.
D) a single measure of the tax burden on capital.

Question 45

All else equal, a decrease in effective tax rate will lead to

A) a fall in the desired investment.
B) an increase in the interest rate.
C) an increase in the desired investment.
D) an increase in inventory.

Question 46

Suppose your company is in equilibrium, with its capital stock at its desired level. A permanent increase in the tax rate on your firm's revenues now has what effect on your desired capital stock?

A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the after-tax user cost of capital is now lower
D) lowers it, because the after-tax user cost of capital is now higher

Question 47

A temporary increase in government purchases would cause

A) a leftward shift in the saving curve and a leftward shift in the investment curve.
B) a leftward shift in the saving curve and a rightward shift in the investment curve.
C) a leftward shift in the saving curve, but no shift in the investment curve.
D) no shift in the saving curve, but a rightward shift in the investment curve.

Question 48

What is the difference between gross investment and net investment?

A) net investment = gross investment minus taxes
B) net investment = gross investment minus net factor payments
C) net investment = gross investment minus inventory accumulation
D) net investment = gross investment minus depreciation

Question 49

All else equal, a decrease in the expected future MPK will lead to

A) an increase in the desired investment.
B) no change in the desired investment.
C) a fall in the desired investment.
D) an increase in the desired level of capital .

Question 50

When desired national saving equals desired national investment, what market is in equilibrium?

A) the goods market
B) the money market
C) the foreign exchange market
D) the stock market

Question 51

The saving-investment diagram shows that a higher real interest rate due to a leftward shift of the saving curve

A) raises the profitability of investment for firms.
B) causes the amount of firms' investment to increase.
C) increases the total amount of saving because of the increase in the real interest rate.
D) causes the total amounts of saving and investment to fall.

Question 52

In 2001 your firm's capital stock equaled $10 million, and in 2002 it equaled $15 million. The average depreciation rate on your capital stock is 20%. Net investment in 2002 equaled

A) $3 million.
B) $4 million.
C) $5 million.
D) $7 million.

Question 53

An economy has government purchases of 2000. Desired national saving and desired investment are given by S^d = 200 + 5000r + 0.10 Y - 20G
I^d = 1000 - 4000r
When the full-employment level of output equals 5000, then the real interest rate that clears the goods market will be

A) 7.78%.
B) 10.00%.
C) 14.44%.
D) 23.33%.

Question 54

Any change in the economy that raises desired national saving for a given value of the real interest rate will shift the desired national saving curve

A) to the right and increase the real interest rate.
B) to the right and decrease the real interest rate.
C) to the left and increase the real interest rate.
D) to the left and decrease the real interest rate.

Question 55

Calculate the after-tax user cost of capital of a machine that costs $5000 and depreciates at a 25% rate, when the interest rate is 5% and the tax rate on revenue is 25%.

A) $200
B) $275
C) $2000
D) $2750

Question 56

In 2001 your firm's capital stock equaled $10 million, and in 2002 it equaled $15 million. The average depreciation rate on your capital stock is 20%. Gross investment in 2002 equaled

A) $3 million.
B) $4 million.
C) $5 million.
D) $7 million.

Question 57

An economy has government purchases of 1000. Desired national saving and desired investment are given by S^d = 200 + 5000r + .10Y - .20G
I^d = 1000 - 4000r
When the full-employment level of output equals 5000, then the real interest rate that clears the goods market will be

A) 1.11%.
B) 5.56%.
C) 16.67%.
D) 21.11%.

Question 58

Your firm has capital stock of $15 million and a depreciation rate of 10%. Gross investment is $2.5 million. How much is net investment?

A) $13.5 million
B) $2.5 million
C) $1.5 million
D) $1.0 million

Question 59

A higher real interest rate will

A) increase the profitability of new investment.
B) decrease lending of funds from firms to other economic agents.
C) reduce the desired investment of all firms.
D) reduce the desired investment of only those firms that have to borrow.

Question 60

You have just purchased a home that cost $250 thousand. The nominal mortgage interest rate is 8% per annum, mortgage interest payments are tax deductible, and you are in a 30% tax bracket. The expected inflation rate is 4%.Maintenance and other expenses are 8% of the initial value of the house. What is the real user cost of your house?

A) $20 thousand
B) $24 thousand
C) $27 thousand
D) $30 thousand

Question 61

Use a saving-investment diagram to explain what happens to saving, investment, and the real interest rate in each of the following scenarios.
a. Current output rises due to a temporary productivity increase.
b. The tax code changes so that business firms face higher tax rates on their revenue (offset by other lump-sum tax changes so there is no overall change in tax revenue).
c. The government increases spending temporarily for a one-year project to turn mercury into gold.
d. The average educational level rises, inducing an increase in the future marginal productivity of capital.

Question 62

In 2001 the federal government changed the withholding amounts for personal taxes. The change meant that people wouldn't have as much withheld from their paycheques. But there was no change in the tax code itself, so the amount of tax due in April 2002 was not changed. How would consumption and saving respond to this withholding change (note: you may assume a real interest rate of 0%)?

Question 63

If consumers foresee future taxes completely, a reduction in taxes this year that is accompanied by an offsetting increase in future taxes would cause

A) an increase in the real interest rate and a decrease in desired investment.
B) a decrease in the real interest rate and an increase in desired investment.
C) a decrease in the real interest rate and an uncertain effect on desired investment.
D) a change in neither the real interest rate nor desired investment.

Question 64

A firm has current and future marginal productivity of capital given by MPK = 10,000 - 2K + N, and marginal productivity of labour given by MPN = 50 - 2N + K. The price of capital is $5,000, the real interest rate is 10%, and capital depreciates at a 15% rate. The real wage is $15.
a. Calculate the user cost of capital.
b. Find the firm's optimal amount of employment and the size of the capital stock.

Question 65

Jane wants to save $1000 of current income. With an RRSP, no taxes are paid on income or interest until the money is withdrawn in five years. Without an RRSP, taxes must be paid whenever income or interest is received. Jane's tax bracket is 35%, and the nominal interest rate is 8%.
a. How much money will Jane have if she puts her money in an RRSP and withdraws the money in five years?
b. How much money will Jane have if she does not put her money in an RRSP, but rather in a regular (taxable) savings account, for five years?
c. How much does Jane gain in five years by using an RRSP rather than a regular savings account?

Question 66

A lump-sum increase in current taxes would cause interest rates to

A) fall if Ricardian equivalence held.
B) fall if Ricardian equivalence did not hold.
C) fall regardless of whether Ricardian equivalence held.
D) rise.

Question 67

The one-year T-bill rate was 8% on 1/1/00, 7% on 1/1/01, and 6% on 1/1/02. The GDP deflator (1996 = 100) was 150 on 1/1/00, 159 on 1/1/01, 165.4 on 1/1/02, and 173.6 on 1/1/03. The tax rate on interest income is 30%.
a. Calculate the after-tax nominal rate of return for 2000, 2001, and 2002.
b. If you began with $1000 on 1/1/00 and invested in T-bills each year (paying taxes at the end of each year), how much would you have in nominal terms on 1/1/01? How much would you have in real terms (1996 dollars)?
c. How much was your nominal after-tax interest earned in part b over the three years? How much did you earn in real after-tax dollars?

Question 68

An invention that raises the future marginal product of capital would cause an increase in desired investment, which would cause the investment curve to shift to the ________ and would cause the real interest rate to ________.

A) right; increase
B) right; decrease
C) left; increase
D) left; decrease

Question 69

Suppose the stock price for a firm in Manitoba is $10 per share. The firm has 5 machines and 1,000 shares outstanding. Suppose the price of a new machine is $1,500.
a. What is Tobin's q for this firm?
b. Should this firm make new investment (buy new machine)? Why?
c. Assume the firm's stock price falls down to $6 per share. Should the firm buy new machine?
d. Assume the price of a new machine rises to $1,800. Using the original information for the other variables, should the firm make new investment?

Question 70

Suppose you divide your life into two periods-working age and retirement age. When you work, you earn labour income Y; when retired, you earn no labour income, but must live off your savings and the interest it earns. You save the amount S while working, earning interest at rate r, so you have (1 + r)S to live on when retired. Because you don't need to consume as much when retired, you want to set consumption when working twice as high as consumption when retired.
a. Suppose you earn $1 million over your working life and the real interest rate for retirement saving is 50%. How much will you save and how much will you consume in each part of your life?
b. Suppose your current income went up to $2 million when working. Now what will you save and how much will you consume each period?
c. Suppose a social security system will pay you 25% of your working income when you are retired. Now (with Y = $1 million, as in part a) how much will you save and how much will you consume each period?
d. Suppose the interest rate rises (starting from the situation in part a). Will you save more or less?

Question 71

Consider a Keynesian consumption function with desired consumption equal to 0.9 Y, where Y is income. Government purchases are $1000, net exports are zero, and desired investment varies with real interest rate according to the following schedule: Assume the interest rate adjusts so that the economy gets to equilibrium. Equilibrium output at full employment is $50,000. Find the values of consumption, investment, and the real interest rate at full-employment equilibrium.

Question 72

The nominal interest rate on taxable bonds is 8%, while on municipal bonds (which aren't taxable) it is 5%. The expected inflation rate is 3% and the tax rate on interest income is 40%. Calculate the expected after-tax real interest rate on both bonds. Which would be the better investment? Now suppose the actual inflation rate turned out to be 6%. Which bond was the better investment? Would your answer change if inflation had turned out to be 0%?

Question 73

If consumers foresee future taxes completely, a reduction in taxes this year that is accompanied by an offsetting increase in future taxes would cause

A) a rightward shift in the saving curve and a rightward shift in the investment curve.
B) a shift in neither the saving nor the investment curve.
C) a leftward shift in the saving curve, but no shift in the investment curve.
D) no shift in the saving curve, but a rightward shift in the investment curve.

Question 74

A temporary supply shock, such as a drought, would

A) increase the marginal product of capital and increase desired investment.
B) decrease the marginal product of capital and decrease desired investment.
C) have little or no effect on desired investment.
D) decrease both the marginal product of capital and the marginal product of labour in the long-term future.

Question 75

A temporary decrease in government purchases would cause

A) an increase in the real interest rate and a decrease in desired investment.
B) a decrease in the real interest rate and an increase in desired investment.
C) a decrease in the real interest rate and an uncertain effect on desired investment.
D) an uncertain effect on the real interest rate and an increase in the level of desired investment.

Question 76

Perpetual plastic plant makers cost $200 each. The number of plants that your firm expects to produce each year for each level of capital stock is as follows: The plants sell for $1 each and your firm faces no other costs. The real interest rate is 10% and the depreciation rate of capital is 15%. There is a 20% tax on your firm's revenues from selling these plants.
a. What is the firm's tax-adjusted user cost of capital?
b. What is the marginal product of capital for each number of machines (1, 2, 3, 4, and 5)?
c. How many machines should the firm buy? What is their production, pretax revenue, and profit after deducting taxes, interest, and depreciation?

Question 77

What are the economic consequences of reductions in defense spending by the government? What happens to national saving, the interest rate, and investment?