Question

Montpelier, a small town in Ohio, earns $75 million and spends $46.5 million. If their income falls to $67 million, they will spend $41 million. Full employment is achieved when income is $79 million.

1. Calculate the average propensity to consume when Montpelier earns $75 million
2. Calculate the average propensity to save when Montpelier earns $75 million
3. Calculate the marginal propensity to consume when income falls from $75 million to $67 million
4. Calculate the spending multiplier for Montpelier
5. Is Montpelier in a recessionary or inflationary period?
6. If the government wants to change their spending level to get Montpelier to reach full employment, how much will they have to adjust their spending when Montpelier is earning $67 million

Answer 1

(a)

Income	Consumption
$75 million	$46.5 million
$67 million	$41 million

Average propensity to consume = Consumption / Income.

Average propensity to consume when Montpelier earns $75 million = $46,5 million / $75 million

Average propensity to consume when Montpelier earns $75 million = 0.62

APC = 0.62 (when earns $75 million)

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(b) APS + APC = 1

APS = 1 - APC

APS = 1 - 0.62

APS = 0.38.

Average propensity to save when Montpelier earns $75 million = 0.38.

Note: Average propensity to save (APS) = Save / Income.

Since, income = Save + Consumption

APC + APS = 1.

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(c) Marginal propensity to consume (MPC) = (Change in consumption / Change in Income)

Income falls from $75 million to $67 million due to which the consumption falls from $46.5 million to $41 million

Change in income = ($67 million - $75 million) = -$8 million

Change in consumption = ($41 million - $46.5 million) = -$5.5 million

MPC = (-$5.5 million / -$8 million)

MPC = 0.6875

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(d) Spending multiplier = 1 / (1 - MPC)

Spending multiplier = 1 / (1 - 0.6875)

Spending multiplier = 3.2

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(e) Currently the economy is earning $67 million and full employment is achieved when income is $79 million

The current income is less than the full employment income. It implies Montpelier is in a recessionary period.

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(f) Current income = $67 million

Full employment income = $79 million

There is a need to increase the current income by $12 million in order to reach the full employment.

Change in income = $12 million

Spending multiplier = (Change in income / Change in government spending)

3.2 = ($12 million / Change in government spending)

Change in government spending = $12 million / 3.2

Change in government spending = $3.75 million

Government has to increase its spending by $3.75 million in order to reach full employment.