Question

. Give an hypothetical numerical example to show the relationship between the marginal propensity to consume (MPC) and the multiplier (m)? How do you conclude the relationship between these two? b. Considering both the Keynesian and the aggregate demand-supply frameworks, if households as a group experience an increase in wealth at a given price level, what happen to total expenditure (TE), aggregate demand (AD) and Real GDP. Illustrate and explain the changes using a suitable graph.

Answer 1

a) Hypothetical numerical example for showing relationship between MPC and multiplier

Investment multiplier is the number of times the increase in income exceeds the increase in investment. This is denoted by K and is determined by the change in income and change in investment. Marginal propensity to consume(MPC) is the percentage change in consumption for the change in income. The value of MPC is between 0 to 1

K (multiplier)= 1/ (1-MPC),

Hypothetical example: If MPC= 0.8, then

k= 1/(1-0.8) = 1/0.2 = 5 times.

when the value of MPC is high, then multiplier will be high (MPC=0.8 k= 5)

when the value of MPC is low, then multiplier will be low ( MPC=0.2 k=1.25)

when the value of MPC is 0. then the multiplier will be 1

when the value of MPC is 1, then the multiplier will be infinity

b) When the wealth of the households increase in a group, it will have a positive effect on consumption and investment expenditure. As studied in the Keynesian model Aggregate Demand is determinant by consumption expenditure, investment expenditure, government spending and net factor income from abroad.

AD= C+ I+G+(X-M)

this AE determines the total amount that the firms and households plan to spend on goods and services at a particular level of income. The Aggregate expenditure method is one approach or method to calculate the real GDP. This can be explained in a diagram

The initial Aggregate Demand curve is AD (AD= C+I+G+(X-M) , when the wealth of the households increases, the consumption expenditure increase. When the consumption increases more is produced and more is invested. There will be an increase in the consumption expenditure and investment expenditure. Hence the Aggregate Demand curve shifts from AD to AD¹. Due to the shift in the Aggregate Demand, the real GDP increases from Y0 to Y1.

to sum up, when wealth increase of the households as a group increases, total expenditure increases, aggregate demand rises and the real GDP increases as well