Question

Q.4  The following relationships hold in economy of Matata Island:

? = 320 + 0.4(? − ?)

? = 150

? = 275

? = 200

a) Explain the concepts of marginal propensity to consume (MPC) and marginal propensity to save (MPS).

b) What is the MPC for this economy?

c) Explain the concepts of the autonomous spending and tax multipliers.

d) What is the autonomous spending multiplier for this economy?

e) What is the equilibrium level of income for this economy?

Answer 1

(a) Marginal propensity to consume refers to the change in consumption due to change in disposable income by an unit.

Marginal propensity to save refers to the change in saving due to change in disposable income by an unit.

MPC + MPS = 1

Disposable income (Yd) = (Y -T)

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(b) ? = 320 + 0.4(? − ?)

? = 320 + 0.4Yd.

MPC = ΔC / ΔYd

=> MPC = 0.4

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MPS + MPC = 1

=> MPS = 1 - MPC

=> MPS = 1 - 0.4

=> MPS = 0.6

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(c) Autonomous spending multiplier shows the change in equilibrium GDP due to change in autonomous spending by an unit.

Note: Autonomous spending are those spending which remains constant (or fixed). For example, G and I in this question.

Tax multiplier shows the change in equilibrium GDP due to change in tax by an unit.

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(d) Autonomous spending multiplier = 1 / (1-MPC)

Autonomous spending multiplier = 1 / (1-0.4)

Autonomous spending multiplier = 1 / 0.6

Autonomous spending multiplier = 1.67

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(e) At equilibrium in closed economy , Y = C + I + G

=> Y = 320 + 0.4(Y-T) + 150 + 275

=> Y = 745 + 0.4 (Y - 200)

=> Y = 745 + 0.4Y - 80

=> Y - 0.4Y = 665

=> 0.6Y = 665

=> Y = (665 / 0.6)

=> Y = 1108.33 (Equilibrium income)