Question

Consider an economy where consumers spend C, businesses invest I, and there is no government for simplicity (TR = T = 0). In this economy we can write Consumption as: ? = ? + MPC∗GDP The economy also imports some amount of goods, but it does not export anything. We can represent imports (M) by the following: ? = ? + MPCF ∗ ?DP where MPCF can be thought of as the marginal propensity to consume foreign goods and F is the amount of imports that will occur even with no disposable income. (a) What is the total aggregate expenditure equation in this economy? What is the equilibrium condition? Solve for GDP* as a function of all other variables. Is the spending multiplier larger or smaller than our typical spending multiplier? Why is it larger or smaller? Explain the intuition behind the results. Is the spending multiplier larger or smaller than 1? Why is it larger or smaller? Explain the intuition behind the results.

Answer 1

hence the open economy spending multiplier is less than the closed economy spending multiplier this is because in when their is na increase in autonomous expenditure income increases and this increase in income is completely spent by households on the goods produced in domestic economy in case the economy is closed i.e. their is no leakages but in case of open economy a part of the increase in income is also spent on imports i.e. goods which are not produced in the domestic economy hence their are leakages in open economy. Hence open economy multiplier will be less than closed economy multiplier.

Now the open economy multiplier can be larger than 1 in case the marginal propensity to consume of domestic good is more than marginal propensity to consume foreign good. This scenario is a highly possible scenario and in such case (MPC - MPCF) will be positive and hence 1 - (MPC - MPCF) will be less than 1 and ultimately 1/(1 - (MPC - MPCF)) will be greater than one and this is because consumers' propensity to spend on domestic goods is more than propensity to spend on foreign goods and hence increased income is spent more on domestic goods than on foreign goods hence increase in domestic income is more than 1. Similarly, in case the marginal propensity to consume of domestic good is less than marginal propensity to consume foreign good. This scenario is a highly impossible scenario and in such case (MPC - MPCF) will be negative and hence 1 - (MPC - MPCF) will be more than 1 and ultimately 1/(1 - (MPC - MPCF)) will be less than one and this is because consumers' propensity to spend on domestic goods is less than propensity to spend on foreign goods and hence increased income is spent more on foreign goods than on domestic goods hence increase in domestic income is less than 1.