Question

1. The multiplier effect Consider a hypothetical economy where there are no taxes and no international trade. Households spend $0.90 of each additional dollar they earn and save the remaining $0.10. If there are no taxes and no international trade, the oversimplified multiplier for this economy is. Suppose investment spending in this economy decreases by $200 billion. The decrease in investment will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on. Fill in the following table to show the impact of the change in investment spending on the first two rounds of consumption spending and, eventually, on total output and income. Change in Investment SpendingChange in Investment Spending =    ?$200 billion?$200 billion First Change in ConsumptionFirst Change in Consumption =    billion Second Change in ConsumptionSecond Change in Consumption =    billion •• •• •• •• •• •• Total Change in OutputTotal Change in Output =    billion Now consider a more realistic case. Specifically, assume that our hypothetical economy opens up to international trade and that its government collects taxes. In this case, the multiplier will be the oversimplified multiplier you found earlier. Suppose that the price level in our economy remains the same but now, out of each additional dollar of income, households save $0.10, pay $0.05 in taxes, and spend $0.10 on imported goods. In this case, accounting for the impact of taxes and imports, the multiplier in this economy is, and a $200 billion decrease in investment spending will lead to abillion in output.

Answer 1

Multiplier in case of no taxes and no imports = 1/1-MPC = 1/1-0.9 = 10

Change in Investment Spending	=	?$200 billion
First Change in Consumption	=	-$180 billion
Second Change in Consumption	= -$162	billion
••		••
••		••
••		••
Total Change in Output	= -$2000	billion

Explanation: A decline in investment spending by 200 billion causes a decline in income by 200 billion. Since the MPC is 0.9, the consumption decline by 200*0.9 = 180 billion. This 180 billion decline in consumption further causes a decline in Income by 180 billion. Thus the consumption further falls by 180*0.9 = 162 billion.

Total change in income = multiplier*change in investment = 10*200 = 2000 billion.

Now, taxes = 0.05, Marginal propensity to Import MPI = 0.1

Multiplier = 1/MPS + MPI + Tax = 1/0.1+0.1+0.5 = 1/0.25 = 4

Total change in income = multiplier*change in investment = 4*200 = 800 billion.

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