Question

: The US has just entered a major recession. Please describe what will happen as the US Government uses Expansionary Fiscal Policy to aid the economy. Assume that the marginal propensity to expend is 0.9 and therefore the multiplier is 10. According to the multiplier model, an increase in autonomous consumption of 200 would raise the equilibrium level of income by 2000. 1) Explain how the multiplier process amplifies the initial shift in autonomous expenditures. 2) Had the MPE only been .5, what would have needed to happen to get the economy back to equilibrim?

Answer 1

We have been given the following information

1. Government has used expansionary fiscal policy to aid the economy.
2. Marginal propensity to expand is equal to 0.9
3. The multiplier is 10. Multiplier = 1/(1 – MPE) = 1/(1 – 0.9) = 10

Part 1: When there is an increase in government spending then initially the national income is directly increased by the amount of increase in the government spending. For instance, if the government spending is increased by $200 then initially the national income will increase directly by $200. The rest of the $1,800 increase is indirect. This is because the multiplier is 10 and ultimately the income will increase by $2,000.

In other words, when income is directly increased by $200 then some part of it is spent on consumption by individuals. The increase in expenditure will further increase income in the economy by raising the demand. This process of income expansion will continue till the overall income in the economy has increased by $2,000.

Part 2: If the MPE would have been 0.5 then the multiplier would have been 1/(1 – MPE) = 1/(1 – 0.5) = 2. This means if the government wanted the national income to increase by $2,000 then it would have to increase its spending by $1,000.