Question

1. Consider the full multiplier model with trade and government.  Let’s assume the MPC is .75 and the initial equilibrium is at $10,000.  If Investment Expenditure drops by $500 what happens to equilibrium?  What change in government policy would a Keynesian economist recommend in this situation if the initial equilibrium at $10,000 corresponded to full employment? Give a specific $ amount for the necessary change in government spending.  

2. Tell me about the logic/process by which an increase in G will cause “multiplier effects”.  Describe at least 2 rounds for a scenario where the MPC is .6 and the government increases G by 100.  What is the formula for the multiplier? Give 2 versions!

Do multiplier effects make a recession worse if I or X suddenly drop? Explain

Answer 1

The value of multiplier : 1/1-MPC

MPC = 0.75

Multiplier = 1/0.25* = 4

Drop in the investment : 500

Total change in the income: 500*4

= 2000

Now new equilibrium will be the 8000 which is below the full employment.

Now again government needs to raise its expenditure level to raise the level of GDP to natural level.

Here government again needs to increase the expenditure equal to the $500.

The expenditure by the one is income of another entity. When the government raises the level of expenditure, it causes the rise in the income and furter it induces the consumption and again the consumption expenditure is income of other entities again.

Change in the income = Change in expenditure + Change in the expenditure(MPC) +Change in the expenditure(MPC)^2

Change in the income = 100 + 100*0.6 +100*0.6^2

Formula multiplier = 1/1-MPC

= 1/MPS.

The drop in the expenditure fall in the due to the fall in the I or X would cause the severe recession in the economy. The multiplier effect will move in the negative direction thereby causing the rise in the unemployments.