Question

1. The multiplier effect

Consider a hypothetical economy where there are no taxes and no international trade. Households spend $0.50 of each additional dollar they earn and save the remaining $0.50. If there are no taxes and no international trade, the oversimplified multiplier for this economy is

.

Suppose investment spending in this economy decreases by $100 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	=  =	−$100 billion−$100 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 the government in our hypothetical economy collects income 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 and that there is still no international trade. Now, however, the government decides to implement an income tax of 5% on each dollar of income. The MPC and MPS, however, remain the same as before. In this case, after accounting for the impact of taxes, the multiplier in this economy is     , and a $100 billion decrease in investment spending will lead to a      billion   in output.

Answer 1

Marginal propensity to consume (MPC) shows how much of $1 additional income is consumed, whereas marginal propensity to save (MPS) indicates the fraction of $1 additional income that is saved. For instance, if a person spends $0.5 dollars of $1 increase in her income, then her MPC is 0.5. The fraction consumed and the fraction saved must be equal to the whole change in income.

MPS + MPC = 1

The spending multiplier determines how much larger the change will be in the economy's income, when there is a change in initial spending. Multiplier is the reciprocal of MPS.

In this question, MPS is 0.5, hence the spending multiplier is calculated as:

Multiplier = 1 / MPS = 1 / 0.50 = 2

Thus, we can fill out the blanks as follows:

Consider a hypothetical economy without government or international trade. . The marginal propensity to consume (MPC) for this economy is 0.5; the marginal propensity to save (MPS) for this economy is 0.5; and the multiplier for this economy is 2.

Investment spending decreases by -$100 billion. A decrease in investment spending is a fall in income for households. Households will spend only a fraction of decreased income. That fraction is MPC. Since MPC=0.5 in this economy. the first round of consumption will decrease by:

Decrease in consumption of first round = $0.5 * -$100 billion = -$50 billion

The decrease consumption of -$50 billion will create an decrease income of -$50 billion income in the second round. Thus, -$50 billion of income will increase consumption by -$25 billion (=0.50x$-50 billion) in the second round. The total change in output after several rounds, is calculated as follows:

Total change in output = Multiplier * Initial change in investment

Total change in output = 2 * -$100 billion = -$200 billion

Change in Investment Spending	= $250 billion
First-Round Change in Consumption	=-$50 billion
Second-Round Change in Consumption	=-$25 billion
Total Change in Output	=-$200 billion