Answered: The multiplier effect of a change in…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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The multiplier effect of a change in government purchases

Suppose there is some hypothetical closed economy in which households spend $0.80 of each additional dollar they earn and save the remaining $0.20.

The marginal propensity to consume (MPC) for this economy is (0.2 or 0.8 or 1 or 1.25 or 5), and the spending multiplier for this economy is (0.2 or 0.8 or 1 or 1.25 or 5).

Suppose the government in this economy decides to increase government purchases by $400 billion. The increase in government spending will lead to an increase in income, creating an initial change in consumption equal to (320 billion or 2000 billion or 1000 billion or 80 billion or 160 billion). This increases income yet again, leading to a second change in consumption equal to (160 billion or 80 billion or 1000 billion or 2000 billion or 256 billion). The total change in demand resulting from the initial change in government spending is (2 trillion or 0.8 trillion or 1.6 trillion or 3.2 trillion).

PRICE LEVEL
140
135
130
125
120
115
110
105
100
0
AD
1
1
3
5
OUTPUT (Trillions of dollars)
2
6
7 8
A
AD2
?

Expert Solution

Step 1

Marginal propensity to consume (MPC) measures the change in consumption due to a change in income.

Marginal propensity to save (MPS) measures the change in saving due to a change in income.

The sum of MPC and MPS is one.

i.e., MPC + MPS = 1

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