Question

Please answer all the questions. Thank you

1. Define the investment / spending and tax multipliers.

2. Assume marginal propensity to consume (mpc) is 0.65. Calculate the change in income due to the following:

1. Exogenous / autonomous investment increases by $ 500 billion.

2. Exogenous / autonomous government spending increases by $ 100 billion.

3. Exogenous / autonomous taxes increase by $ 100 billion.

4. All three occur simultaneously. Compare your answers in a), b), and c).

Answer 1

(1)

When investment (spending) rises (falls), total income in the economy rises (falls) by an amount higher than initial increase (decrease) in investment (spending). Therefore,

Spending multiplier = Total increase in income / Initial increase in investment (spending) = 1 / (1 - MPC)

When tax rises (falls), total income in the economy falls (rises) by an amount higher than initial increase (decrease) in tax. Therefore,

Tax multiplier = Total decrease in income / Initial increase in tax = -MPC / (1 - MPC)

(2)

When MPC = 0.65,

Spending multiplier = 1 / (1 - 0.65) = 1 / 0.35 = 2.86

Tax multiplier = -0.65 / (1 - 0.65) = -0.65 / 0.35 = -1.86

(a) Increase in income ($ Billion) = Increase in investment x Spending multiplier = 500 x 2.86 = 1430

(b) Increase in income ($ Billion) = Increase in government spending x Spending multiplier = 100 x 2.86 = 286

(c) Decrease in income ($ Billion) = Increase in tax x Tax multiplier = 100 x 1.86 = 186

(d) Net increase in income ($ Billion) = 1430 + 286 - 186 = 1530

(e) Increase in income is highest in case (a) since initial increase in autonomous spending is highest. Since higher tax lowers consumption, a rise in tax has decreased income.