Question

In: Economics

If the MPC is 0.9, what is the size of the multiplier and the total change...

  1. If the MPC is 0.9, what is the size of the multiplier and the total change in real GDP demanded following a $1 billion decrease in spending?
  2. If the MPC is 0.8, what is the size of the multiplier and the total change in real GDP demanded following a $1 billion increase in spending?
  3. If the MPC is 0.75, what is the size of the multiplier and the total change in real GDP demanded following a $10 billion increase in spending?
  4. What are the 3 main tools of monetary policy?

Solutions

Expert Solution

Multiplier is denoted by K and the formula for multiplier is

K = 1/(1-MPC) . or Change in income/change in spending

K = 1/(1-0.9) = 10

10 = change in income/-1 billion

change in income = -10 billion (due to decrease in spending by 1 billion, the income fell by 10 billion)

K = 1/(1-MPC) . or Change in income/change in spending

K = 1/(1-0.8) = 5

5 = change in income/1 billion

change in income = 5 billion (due to increase in spending by 1 billion, the income rose by 5 billion)

K = 1/(1-MPC) . or Change in income/change in spending

K = 1/(1-0.75) = 4

4 = change in income/10 billion

change in income = 40 billion (due to increase in spending by 10 billion, the income fell by 40 billion)

Some of the tools of the monetary policy are

Bank rate - This is the rate at which the central bank of a nation (Fed) lends to the commercial banks of the nation. The central bank controls money supply by reducing or increasing the bank rate.

Open Market Operations - Purchasing and selling securities in the open market by the central bank comes under this tool. To reduce money supply, the central bank sells the securities and purchases them in case of deflationary pressure in the economy.

Cash Reserve Ratio - The percentage of deposits which every bank has to keep as reserve with the central bank. Higher the reserve ratio lower will be the lending capacity of commercial banks and vice versa. The central bank uses this tool most often to control deflationary and inflationary trends in the economy.


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