Question

If a consumer buys an entertainment center at Best Buy for $2,000 and the MPC is .80, what will be the effect on the economy? What if the MPC is .75? Why is there such a difference?

Answer 1

If a consumer spends, it creates a multiplier effect which increases the GDP of the economy. The effect of a consumption spending on the GDP depends on the spending multiplier. Spending multiplier = 1/MPS = 1/(1-MPC) = 1/(1-0.80) = 1/0.20 = 5.

The spending multiplier = 5. This means increasing spending by $1 will increase GDP by $5. So,  $2,000 spending would result in an increase in GDP by $2,000 * 5 = $10,000.

When MPC = 0.75, spending multipler = 1/MPS = 1/(1-MPC) = 1/(1-0.75) = 1/0.25 = 4. So, when MPC = 0.75, $2,000 spending would result in an increase in GDP by $2,000 * 4 = $8,000.

Such a difference in GDP is because of the multiplier effect. MPC refers to the ratio of change in consumption and change in income. When MPC is 0.75, it means when income increases by $1, spending increases by $0.75. The higher the MPC, the higher is its effect on GDP as more portion of the income is spent.