Question

Consider a hypothetical economy where there are no taxes and no international trade. Households spend $0.90 of each additional dollar they earn and save the remaining $0.10. If there are no taxes and no international trade, the oversimplified multiplier for this economy is $_______.

Suppose investment spending in this economy increases by $200 billion. The increase in investment will lead to an increase in income, generating an increase in consumption that increases 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 = $200billion

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 selector 1 _______ (The same as, smaller than, or larger than) 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 10% 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 selector 1 ______, and a $200billion increase in investment spending will lead to a $____billion ______ (increase or decrease) in output.

Answer 1

Household spends $0.90 of each additional dollar they earn.

So,

MPC = 0.90

Calculate the oversimplified multiplier -

Oversimplified multiplier = 1/(1-MPC) = 1/(1-0.90) = 1/0.10 = 10

The Oversimplified multiplier is 10.

Now, investment decreases by $200 billion. This will increase the income by $200 million. With MPC being 0.90, consumption will decrease by ($200 0.90) $180 billion. This will lead to decrease in income by $180 billion, which further decrease the consumption by ($180 0.9) $162 billion.

Total decrease in output = Decrease in investment spending Multiplier = $200 billion 10 = $2,000 billion

Following is the complete table -

change in investment spending	-$200 billion
first change in consumption spending	-$180 billoin
second change in consumption spending	-$162 billion
Total change in output	-$2,000 billoin

In this case, the multiplier will be smaller than the oversimplified multiplier you found earlier.

MPS = 0.10

MPT = 0.05

MPM = 0.10

Calculate the Multiplier -

Multiplier = 1/(MPS+MPT+MPM) = 1/(0.10+0.05+0.10) = 1/0.25 = 4

In this case, accounting for the impact of taxes and imports, the multiplier in this economy is 4, and a $200 billion decrease in investment spending will lead to a $800 billion decrease in output.

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