Question

Suppose that investment demand increases by $700 billion in a closed and private economy (no government or foreign trade). Assume further that households have a marginal propensity to consume of 90 percent.

(a) Compute four rounds of multiplier effects.

Instructions: Enter your responses rounded to the nearest one decimal place.

	Changes in This Cycle's Spending (in billions)	Cumulative Change in Spending (in billions)
First cycle	700.0	700.0
Second cycle
Third cycle
Fourth cycle

(b) What will be the final cumulative impact on spending?

Instructions: Enter your response rounded to the nearest whole number.

$ billion

Answer 1

a.

Multiplier effect in each cycle would be calculated as below:

Current cycle spending = Earlier spending × MPC

Cumulative spending = Current cycle spending + Earlier cycle spending

Second cycle:

Current cycle spending = 700 × 90% = 630

Cumulative spending = 630 + 700 = 1,330

Third cycle:

Current cycle spending = 630 × 90% = 567

Cumulative spending = 567 + 630 + 700 = 1,897

Fourth cycle:

Current cycle spending = 567 × 90% = 510.3

Cumulative spending = 510.3 + 567 + 630 + 700 = 2,407.3

b.

The final impact would be on multiplier effect.

Multiplier = 1 / (1 – MPC)

                 = 1 / (1 – 0.90)

                 = 1 / 0.10

                 = 10

Therefore, spending increases 10 times.

Final cumulative spending = Increase in investment × Multiplier

                                            = $700 billion × 10

                                            = $7,000 billion (Answer)