Question

In a closed economy with no foreign trade, spending on consumer goods (C) is related to national income (Y) according to the table below : -

National Income (Y) (£ billion)	120	160	200	240	280
Consumption (C) (£ billion)	80	110	140	170	200
Injections (J) (£ billion)
Aggregate Demand (AD) (£ billion)

Assuming that the government is spending £30 billion per year on the infrastructure and firms are investing £30 billion

(a) What is the equilibrium level of national income (Y)?               

(b) Calculate the marginal propensity to consume domestic goods and services.                                                                                         

                                                                                                          

(c) Calculate the value of the multiplier in this case.                        

(d) Using a diagram to help your answer, explain what would happen if government spending rose by £20 billion.                                          

Answer 1

(a) Injections = investment + government spending + export

Since, there is no export

=> Injections = investment + government spending

Y (£ billion)	C (£ billion)	I (£ billion)	G (£ billion)	Injection (£ billion)	AD (£ billion)
120	80	30	30	60	140
160	110	30	30	60	170
200	140	30	30	60	200
240	170	30	30	60	230
280	200	30	30	60	260

At equilibrium point, Y = AD.

Thus, equilibrium level of national icome is £200 billions.

------

(b) Every £40 billion increase in Y leads to increase in C by £30 billion

MPC = Change in C / Change in Y

=> MPC = (£30 billion / £40 billion)

=> MPC = 0.75

------

(c) Multiplier = 1 / (1-MPC)

=> Multiplier = 1 / (1-0.75)

=> Multiplier = 1/0.25

=> Multiplier = 4

----

(d) Government spending increases by £20 billion

=> Multiplier = Change in equilibrium national income / Change in govenment spending

=> 4 = (Change in equilibrium national income / £20 billion)

=> Change in equilibrium national income = 4 * £20 billion

=> Change in equilibrium national income = £80 billion

Thus, the national income will increase by £80 billion.

Increase in government spending will increase the AD, which further increase the equilibrium national income

Y (£ billion)	C (£ billion)	I (£ billion)	G (£ billion)	Injection (£ billion)	New AD (£ billion)
120	80	30	50	80	160
160	110	30	50	80	190
200	140	30	50	80	220
240	170	30	50	80	250
280	200	30	50	80	280