Deck 19: The Microfoundations of Consumption and Investment

Question 1

According to Modigliani's life-cycle hypothesis, the consumption function shifts upward as _____ increases.

A)income
B)wealth
C)the marginal propensity to consume out of income
D)the number of years until retirement

Answer 1

wealth

Question 2

Examination of data from households shows that households with high current income _____ than do households with low current income.

A)consume less
B)save less
C)save a smaller fraction of current income
D)save a larger fraction of current income

Answer 2

save a larger fraction of current income

Question 3

Empirical studies of Franco Modigliani's life-cycle hypothesis show that:

A)most elderly individuals try to exhaust all their savings by the time they die.
B)the elderly do not seem to run down their wealth in old age, as a simple version of the theory would predict.
C)elderly individuals generally do not want to leave bequests for their children.
D)precautionary saving is not an important saving motive for the elderly.

Answer 3

the elderly do not seem to run down their wealth in old age, as a simple version of the theory would predict.

Question 4

John Maynard Keynes believed that:

A)consumers will save more if the interest rate is high.
B)consumers will consume more if the interest rate is high.
C)if consumers consume less, the interest rate will be high.
D)the interest rate is relatively unimportant to the consumption decision.

Question 5

The marginal propensity to consume is the:

A)ratio of consumption to income.
B)amount consumed out of an additional dollar of income.
C)amount available for consumption after precautionary saving.
D)ratio of consumption to wealth.

Question 6

According to the life-cycle model, when wealth and income increase together in the long run, the average propensity to consume:

A)increases.
B)decreases.
C)remains constant.
D)can either increase or decrease.

Question 7

According to Modigliani's life-cycle hypothesis, if a consumer wants equal consumption in every year, and the interest rate is zero, there are 40 years until retirement, and 60 years of life remaining, then the marginal propensity to consume out of income equals:

A)0.016.
B)0.40.
C)0.60.
D)0.67.

Question 8

According to Franco Modigliani's life-cycle hypothesis, the time of life at which an individual should have the largest amount of wealth is at:

A)birth.
B)death.
C)retirement.
D)their parents' death.

Question 9

According to the life-cycle model, the average propensity to consume does not fall as income increases in the long run because:

A)wealth and income grow together.
B)as income increases wealth decreases.
C)saving is constant over the life cycle.
D)wealth is constant over the life cycle.

Question 10

According to the life-cycle model, when wealth is constant in the short run, the average propensity to consume _____ as income increases.

A)increases
B)decreases
C)remains constant
D)can either increase or decrease

Question 11

Precautionary saving is saving for:

A)retirement, when income falls.
B)unpredictable expenses.
C)bequests to benefit children.
D)repayment of debt previously incurred.

Question 12

Which of the following conjectures that underlie the Keynesian consumption function is not consistent with aggregate Canadian and U.S. data?

A)The marginal propensity to consume is between 0 and 1.
B)The average propensity to consume decreases as income increases.
C)There is a high correlation between income and consumption.
D)Current income is a determinant of consumption.

Question 13

The consumption decisions of individuals are not important for the:

A)determination of the steady-state capital stock.
B)determination of fiscal-policy multipliers.
C)determination of aggregate demand.
D)determination of sticky prices.

Question 14

John Maynard Keynes believed that the marginal propensity to consume:

A)is zero.
B)is between zero and one.
C)is one.
D)increases as income increases.

Question 15

According to Modigliani's life-cycle hypothesis, if a consumer wants equal consumption in every year and the interest rate is zero, then the marginal propensity to consume out of wealth _____ as years _____ decrease.

A)increases; of life remaining
B)decreases; of life remaining
C)increases; until retirement
D)decreases; until retirement

Question 16

Economists based their prediction that secular stagnation would occur as economies prospered on the conjecture that:

A)the marginal propensity to consume is greater than zero.
B)the marginal propensity to consume is less than one.
C)the average propensity to consume falls as income rises.
D)income is the primary determinant of consumption.

Question 17

The life-cycle model assumes that consumers use saving and borrowing to _____ consumption over their life cycle.

A)increase
B)decrease
C)smooth
D)vary

Question 18

The average propensity to consume is the:

A)ratio of consumption to income.
B)amount consumed out of an additional dollar of income.
C)amount available for consumption after precautionary saving.
D)ratio of consumption to wealth.

Question 19

John Maynard Keynes believed that the average propensity to consume:

A)is constant.
B)increases as income increases.
C)decreases as income increases.
D)is less than the marginal propensity to consume.

Question 20

Kuznets' findings were consistent with a short-run consumption function with a _____ APC, and a long-run consumption function with a _____ APC.

A)constant; constant
B)constant; falling
C)falling; constant
D)falling; falling

Question 21

According to Friedman's permanent-income hypothesis, if the marginal propensity to consume out of permanent income equals 0.9 and current income equals $55,000 (of which $5,000 is transitory income), then consumption should equal:

A)$5,000.
B)$45,000.
C)$49,500.
D)$55,000.

Question 22

According to Friedman's permanent-income hypothesis, the marginal propensity to consume out of permanent income is _____ the marginal propensity to consume out of transitory income.

A)greater than
B)less than
C)equal to
D)one minus

Question 23

According to the permanent-income hypothesis, consumption depends primarily on _____ income.

A)current
B)nominal
C)permanent
D)transitory

Question 24

Milton Friedman argued that, over long periods of time, the average propensity to consume is constant because, over these long periods of time:

A)the variation in income is dominated by the transitory component.
B)the variation in income is dominated by the permanent component.
C)it is the behaviour of the average consumer that dominates.
D)income averages out to a constant.

Question 25

Transitory income is:

A)disposable income.
B)average income.
C)random deviations from average income.
D)current income.

Question 26

According to the permanent-income hypothesis, if consumers receive a permanent increase in their salary then they will:

A)save most of it in the current year.
B)spend most of it in the current year.
C)spend one half of it and save one-half of it in the current year.
D)not alter their consumption or saving in the current year.

Question 27

Recent research by Laibson and other economists recognizes the importance of incorporating _____ effects into the study of consumer behaviour.

A)technological
B)meteorological
C)environmental
D)psychological

Question 28

According to the permanent income hypothesis, households will finance a temporary increase in taxes by: reducing _____ or increasing _____.

A)consumption; saving
B)saving; borrowing
C)permanent income; transitory income
D)transitory income; permanent income

Question 29

The success of the "Save More Tomorrow" program assumes that consumers:

A)smooth consumption over their life cycles.
B)save a constant fraction of their permanent incomes.
C)require help controlling their desires for instant gratification.
D)save only their transitory incomes.

Question 30

Milton Friedman viewed current income as the sum of permanent income and:

A)bonus income.
B)transitory income.
C)temporary income.
D)surprise income.

Question 31

Recent work on the consumption function suggests that consumption depends on:

A)current income alone.
B)current income and expected future income.
C)current income, expected future income, and interest rates.
D)current income, expected future income, interest rates, and wealth.

Question 32

If consumers correctly anticipate their future incomes:

A)the saving rate will be high when consumers anticipate a boom.
B)the saving rate will be low when consumers anticipate a boom.
C)the saving rate will be low when consumers anticipate a recession.
D)they will be disappointed because future income can never be correctly forecast.

Question 33

If consumers obey the permanent-income hypothesis and have rational expectations, then policy changes affect consumption when the policy changes:

A)are proposed.
B)go into effect.
C)change expectations.
D)do not surprise consumers.

Question 34

Whether workers must "opt into" or "opt out of" a retirement savings plan _____ make a difference if workers are rational optimizers and _____ make a difference if workers' behaviour exhibits inertia.

A)would; would
B)would not; would not
C)would; would not
D)would not; would

Question 35

A binding borrowing constraint will _____ the potency of an announced future tax cut to influence aggregate demand but will _____ the potency of a temporary tax cut.

A)not affect; increase
B)increase; not affect
C)decrease; increase
D)increase; decrease

Question 36

According to the permanent-income hypothesis, if consumers receive a one-time income bonus, then they will:

A)save most of it in the current year.
B)spend most of it in the current year.
C)spend one half of it and save one-half of it in the current year.
D)not alter their consumption or saving in the current year.

Question 37

If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will increase when:

A)previously announced tax reductions are implemented.
B)they receive an anticipated raise.
C)they receive an unexpected inheritance.
D)they make the last payment on their automobile loan.

Question 38

Suppose that the government is considering two tax cuts, one temporary and one permanent. Each cut will give each taxpayer the same amount in the first year. The permanent-income hypothesis predicts that:

A)each tax cut will lead to the same amount of consumption in the first year.
B)the temporary tax cut will lead to more extra consumption in the first year.
C)the permanent tax cut will lead to more extra consumption in the first year.
D)the temporary tax cut will lead to no extra consumption at all in the first year.

Question 39

A consumer spending excessively today, intending to start saving for retirement tomorrow, but deciding to continue spending when tomorrow arrives is an example of:

A)an income effect offsetting a substitution effect.
B)time-inconsistent preferences.
C)spending out of permanent income, but not out of transitory income.
D)an intertemporal budget constraint.

Question 40

Economist David Laibson suggests that people end up saving less than they wish because of:

A)an increasing marginal propensity to consume over time.
B)the pull of instant gratification.
C)rarely receiving transitory income.
D)unpredictable changes in consumption.

Question 41

A firm renting out capital does not bear as cost the:

A)lost interest it could have earned by depositing the purchase price of the capital in a bank.
B)wear and tear on the capital.
C)wages of the labour that works with the capital.
D)capital loss or gain in the asset's value.

Question 42

Exhibit: Rental Price of Capital Based on the graph, if the capital market is initially in equilibrium at A with real rental price R₃ / P and capital stock K₂, then holding other factors constant, an improvement in technology that increases the marginal productivity of capital will move:

A)the demand curve from D₂ to D₁.
B)the demand curve from D₂ to D₃.
C)the supply of capital from K₂ to K₁.
D)the supply of capital from K₂ to K₃.

Question 43

The profit rate of a firm that rents capital is equal to:

A)the marginal product of capital minus the cost of capital.
B)the cost of capital minus the marginal product of capital.
C)zero.
D)a negative number, if it is adding to its capital stock.

Question 44

According to the neoclassical model of investment, business fixed investment does not depend on:

A)the realized current profits of firms.
B)the marginal product of capital.
C)the interest rate.
D)tax rules affecting firms.

Question 45

If the capital stock is fixed and something happens to raise the marginal product of capital for any given quantity of capital, then the real rental price of capital will:

A)remain the same.
B)rise.
C)fall.
D)fall and then rise.

Question 46

Other things being equal, the neoclassical model of investment predicts that net investment will increase when the:

A)marginal product of capital falls.
B)price of new capital goods rises.
C)real interest rate falls.
D)depreciation rate rises.

Question 47

Exhibit: Rental Price of Capital Based on the graph, if the capital market is initially in equilibrium at A with real rental price R₃ / P and capital stock K₂, then holding other factors constant, an increase in the quantity of labour employed will move the real rental price of capital to:

A)R₁ / P.
B)R₂ / P.
C)R₄ / P.
D)R₅ / P.

Question 48

If a great wave of immigration increased employment in Canada, this wave would:

A)increase the marginal productivity of capital in Canada.
B)decrease the marginal productivity of capital in Canada.
C)leave the marginal productivity of capital in Canada unchanged.
D)increase the marginal productivity of capital in the country from which the immigrants came.

Question 49

Net investment is the:

A)business fixed investment minus inventory investment.
B)change in the stock of capital.
C)gross investment minus the rate of inflation.
D)gross investment plus the replacement of depreciated capital.

Question 50

The life-cycle model predicts that if the proportion of the population that is elderly increases over the next 20 years, then the national saving rate _____ over the next 20 years.

A)will increase
B)will remain unchanged
C)will decrease
D)may first increase and then decrease

Question 51

The most volatile component of real GDP is:

A)consumption spending.
B)government spending.
C)investment spending.
D)net exports.

Question 52

Exhibit: Rental Price of Capital Based on the graph, if the capital market is initially in equilibrium at A with real rental price R₃ / P and capital stock K₂, then holding other factors constant, an increase in the capital stock to K₃ will change the real rental price of capital to:

A)R₁ / P.
B)R₂ / P.
C)R₄ / P.
D)R₅ / P.

Question 53

The cost of capital for investment, if the price of capital goods rises with the price of other goods, and in the absence of taxes, may be summarized as the:

A)nominal interest rate plus the depreciation rate.
B)real interest rate plus the depreciation rate.
C)purchase price of a capital good multiplied by the sum of the nominal interest rate plus the depreciation rate.
D)purchase price of a capital good multiplied by the sum of the real interest rate plus the depreciation rate.

Question 54

The construction of a new shopping centre is an example of:

A)business fixed investment.
B)residential investment.
C)inventory investment.
D)financial investment.

Question 55

Business fixed investment includes:

A)rental housing that landlords buy to rent out.
B)goods that businesses put aside in fixed storage facilities, including materials and supplies.
C)the fixed cost of borrowing that businesses pay for new equipment.
D)equipment and structures that businesses buy to use in production.

Question 56

In equilibrium, other things being equal, all of the following changes will increase the real rental price of capital except:

A)a lower quantity of labour employed.
B)a lower stock of capital.
C)better technology.
D)a higher labour-capital ratio.

Question 57

The investment spending component of GDP includes all of the following except:

A)business fixed investment.
B)net foreign investment.
C)residential investment.
D)inventory investment.

Question 58

The real cost of capital is the:

A)purchase price of a unit of capital divided by the price level.
B)purchase price of a unit of capital minus the rate of inflation.
C)cost of a unit of capital less the marginal product of capital.
D)cost of buying and renting out a unit of capital measured in units of the economy's output.

Question 59

If the real rental price of capital is $10,000 per unit and the real cost of capital is $9,000 per unit, to maximize profits a firm should:

A)add to its capital stock.
B)let its capital stock shrink.
C)keep its capital stock unchanged.
D)reduce the real rental price of capital.

Question 60

The rate of depreciation is the:

A)nominal interest rate times the purchase price of capital.
B)capital losses resulting from decreases in the price of capital.
C)fraction of the value of capital lost per period because of wear and tear.
D)change in the q value of the firm.

Question 61

Because corporate income tax laws do not define profit to be the same as economic profit, many economists believe that the corporate income tax _____ investment.

A)encourages
B)discourages
C)does not affect
D)promotes excessive

Question 62

The investment tax credit:

A)enables a firm to deduct a certain proportion of each dollar spent on capital goods from its profits.
B)enables a firm to deduct a certain proportion of each dollar spent on capital goods from its tax bill.
C)reduces the corporate tax rate in proportion to each dollar spent on capital goods.
D)allows a firm to count a certain proportion of each dollar spent on capital goods as depreciation expense.

Question 63

According to the neoclassical model of investment, when the real interest rate increases, business fixed investment _____ because the _____ of capital increases.

A)increases; marginal product
B)increases; cost
C)decreases; marginal product
D)decreases; cost

Question 64

The real interest rate should be inversely related to investment in:

A)plant and equipment, home building, and inventories.
B)plant and equipment and home building, but not inventories.
C)plant and equipment and inventories, but not home building.
D)inventories and home building, but not plant and equipment.

Question 65

Economic booms should stimulate investment spending because during booms:

A)the real interest rate increases.
B)corporate tax rates usually increase.
C)the purchase price of capital increases.
D)higher levels of employment increase the marginal product of capital.

Question 66

During a financial crisis, such as the Great Depression or the U.S. recession of 2008-2009, financing constraints become _____ prevalent and investment spending _____.

A)more; increases
B)more; decreases
C)less; increases
D)less; decreases

Question 67

The existence of financing constraints makes investment:

A)more sensitive to current conditions.
B)less sensitive to current conditions.
C)spending follow a random walk.
D)spending increase during recessions.

Question 68

When the capital stock reaches a steady state, the:

A)marginal product of capital must exceed the real cost of capital.
B)marginal product of capital must equal the real cost of capital.
C)real cost of capital must exceed the marginal product of capital.
D)real cost of capital must exceed the real rental price of capital.

Question 69

If Tobin's q is greater than 1, then managers should:

A)increase the capital stock of the firm.
B)maintain the existing capital stock of the firm.
C)allow inventories to run down.
D)decrease the capital stock of the firm.

Question 70

Other things being equal, the ratio of Tobin's q will rise if:

A)stock prices fall.
B)the replacement cost of capital rises.
C)more capital is installed.
D)stock prices rise.

Question 71

The investment demand function would shift for all of the following reasons except:

A)an improvement in technology raises the marginal product of capital.
B)an increase in population raises the demand for housing.
C)an increase in government spending raises the real interest rate.
D)the investment tax credit is reinstated.

Question 72

For a firm facing financing constraints on its investment spending, the most important determinant of how much it invests is the:

A)firm's expected future profitability.
B)firm's current profitability.
C)interest rate.
D)firm's cost of capital.

Question 73

If the replacement cost of installed capital equals $20 trillion and the market value of installed capital equals $25 trillion, then according to q theory, businesses should:

A)add to capital stock.
B)let capital stock shrink.
C)keep capital stock unchanged.
D)reduce product prices to increase profits.

Question 74

Tobin's q equals the:

A)cost of buying and renting out one unit of capital measured in units of the economy's output.
B)marginal product of capital minus the cost of capital.
C)ratio of the replacement value of installed capital to the market value of depreciated capital.
D)ratio of the market value of installed capital to the replacement cost of installed capital.

Question 75

_____ is a share of ownership in a corporation, and the _____ market is the market where these shares are traded.

A)Capital; capital
B)A dividend; stock
C)A bond; capital
D)Stock; stock

Question 76

The function showing total spending on investment would be shifted inward and to the left by:

A)a technological innovation that increases the production function parameter A.
B)any event that raises the marginal product of capital.
C)any event that raises the purchase price of capital.
D)an accident that destroyed one-quarter of Canada's capital stock while leaving the labour supply intact.

Question 77

If corporate profit were defined as the real price of capital minus the properly defined cost of capital, then:

A)having a tax on corporate profits would be more favourable to investment than having no tax at all.
B)having a tax on corporate profits would be less favourable to investment than having no tax at all.
C)having a tax on corporate profits would leave investment incentives the same as having no tax at all.
D)whether a corporate profits tax was more or less favourable for investment than no tax at all would depend on the rate of tax.

Question 78

If firms are earning a profit from installed capital, then this raises the _____ value of installed capital and implies a _____ value of Tobin's q.

A)market; low
B)market; high
C)replacement; low
D)replacement; high

Question 79

The theory behind Tobin's q indicates that:

A)the stock market may be expected to predict every turning point in real GDP.
B)the stock market may be expected to be closely tied to fluctuations in output and employment.
C)every time investment goes up we would expect the stock market to go down.
D)the stock market and the economy are basically independent of each other.

Question 80

The corporate income tax is a tax on the:

A)earnings of employees of a corporation.
B)dividends paid to the shareholders of a corporation.
C)earnings of the managers of a corporation.
D)profits of a corporation.