Question

Let’s assume a simple Keynesian depression economy with a multiplier of 4 and an initial equilibrium income of $3,000. Saving and investment equal $400, and assume “full employment” income is $4,000. (a) What is the value of the MPC? (b) The value of the MPS? (c) Assume the government plans to cover its spending by increasing taxes enough to run a balanced budget. How much will government spending and taxes have to rise to move the economy to full employment? (d) From the initial equilibrium, $3,000, if investment grows by $100 what will be the new equilibrium level of income and savings?

Answer 1

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

=> 4 = 1 / (1 -MPC)

=>(1-MPC) = 1/4

=> (1-MPC) = 0.25

=> MPC = 1 - 0.25

=> MPC = 0.75

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(b) MPC + MPS =1

=> MPS = 1 - MPC
=> MPS = 1 - 0.75

=> MPS = 0.25

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(c) Full employment income is $4000

and equilibrium income is $3000

There is a need to increase the quilibrium income by $1000 in order to reach the full employment income level.

According to balanced budget multiplier concept if we increase the government spending and taxes by same amount, then equilibrium level of income rise by that amount only.

Therefore, in order to increase the equilibrium national income by $1000, there is a need to increase the government spending and taxes by $1000.

Note: Increase in government spending and taxes by same amount will keep the budget balanced.

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(d) Multiplier = Change in equilibrium income / Change in investment spending

=> 4 = (Change in equilibrium income / 100)
=> Change in equilibrium income = 4*100 = 400

Hence, there will be increae in equilibrium income by 400.

New equilirbium income = $3000 + $400 = $3400

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MPS = change in saving / change in income

=> 0.25 = change in saving / 400

=> Change in saving = 0.25 * 400 = 100

New saving = $400 + $100 = $500