Question

3. The spending multiplier effect

Consider a hypothetical economy. Households spend $0.75 of each additional dollar they earn and save the remaining $0.25. The spending multiplier for this economy is.

Suppose investment in this economy increases by $100 billion. The increase in investment will lead to an increase in income, generating an increase in consumption that increases income yet again, and so on.

Fill in the following table to show the impact of the change in investment on the first two rounds of consumption spending and, eventually, on total spending and income.

Change in Investment

=

$100 billion

First Change in Consumption

=

	billion
Second Change in Consumption

=

	billion
•

•

•

•

•

•

Total Change in Spending

=

billion

Now consider the impacts of a change in taxes. The tax multiplier in this question will be____, thus, if taxes increase by $100 billion then spending will change by $ _____ billion.

Answer 1

Households spend (MPC) = 0.75 of each additional dollar they earn

Saving per dollar (MPS) = $0.25

MPC + MPS = 1

Investment in economy increases by $100 billion

Multiplier = [1 / (1 - MPC)] = [ 1 / (1 - 0.75)]

= 1 / 0.25

= 4

It means that investment change by $100 billion will cause total GDP to rise by 4 times of investment change. Thus, total GDP will rise by 100 * 4 = $400 billion

Change in Investment = $100 billion

First round of change in consumption = 100 Billion

Second Round of change in consumption = 100 * MPC = 75 Billion

Third Round of change in consumption = 75 * MPC = 56.25 Billion

Forth Round of change in consumption = 56.25 * MPC = 42.18 Billion

Fifth Round of change in consumption = 42.18 * MPC = 31.64 Billion

and so on....

Total Change in Spending = 400 billion

Tax multiplier would be = [MPC / (1 - MPC)]

If tax increases by $100 billion and MPC is 0.75

Tax Multiplier = 0.75 / 0.25 = 3

GDP will fall by = 3 * 100 = $300 billion