Suppose economists observe that an increase in government spending of 300 crore taka raises the total demand for goods and services to 400 crore taka.

a) Suppose economists observe that an increase in government spending of 300 crore taka raises the total demand for goods and services to 400 crore taka. If these economists ignore the possibility of crowding out effect, calculate the marginal propensity to consume (MPC)?

b) Now suppose economists allow for crowding out. Would their new estimate of the MPC be smaller or larger than your answer to part a, explain.

Expert Solution

A) increase in demand for goods and services implies increase in aggregate demand. The ratio of increase in aggregate demand to increase in government spending is measured by the spending multiplier

Multiplier = 400 / 300

1/(1-MPC) = 4/3

1- MPC = 3/4

MPC = 1/4 = 0.25

Marginal propensity to consume is 0.25.

B) crowding out does not affect the marginal propensity to consume. Note that marginal propensity to consume measures how much of an increased dollar in disposable income is spent. Instead, it is the multiplier which will be reduced because of decrease in investment spending due to crowding out.

Rahul Sunny answered 2 years ago

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