Question

1) What is the marginal propensity to consume? If MPC = 0.6, explain what happens in terms of consumption & savings if your income increases by $100.

2) What is the marginal propensity to save? How is this related to consumption and disposable income? Write the relationship among the three variables with an equation.

3) If the MPC = 0.6 and government spending decreases by $100 billion, what is the total decrease in rGDP in the short run? (how much does AD shift?)

Answer 1

1.

Marginal propensity to consume (MPC) tells the change in consumption with the change in income level.

MPC = Change in consumption / Change in income

If MPC is .6, then it means that with each $100 increase in income, the consumption increases by $60 and vice versa.

Further, Marginal propensity to save = 1 - MPC = 1-.6 = .4

Hence, with increase in income of $100,

Consumption increases by $60, and:

Savings increase by $40.

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2.

Marginal propensity to save (MPS) refers to the change in savings with a change in income. For example, if MPS is .4, then with increase in $100 of income, savings increase by $40.

A higher value of MPS means lower value of MPC. It happens, because: MPS + MPC = 1

Total consumption = Autonomous consumption + MPC * Disposable income

Or

Total consumption = Autonomous consumption + (1-MPS)* Disposable income

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3.

Total decrease in real GDP = Decrease in government spending*(1/(1-MPC))

Total decrease in real GDP = 100*(1/(1-.6))

Total decrease in real GDP = $250