Question

Use the information in the table to answer the following questions. Assume initially that no government spending or taxes occur in this hypothetical economy.

INCOME (Y)	CONSUMPTION (C)	SAVINGS (S)	INVESTMENT (I)
$000	$020	$-20	$40
100	100	00	40
200	180	20	40
300	260	40	40
400	340	60	40

(a) What is the marginal propensity to consume in this economy? What is the marginal propensity to save?
(b) What is the equilibrium level of income? Explain, using Equations.
(c) Suppose investment spending declined by $20. What would be the new equilibrium income and the new level of consumption? What is the size of the multiplier? Why would it be reasonable to assume that an increase in the unemployment rate would be associated with the decline in national income?
(d) What actions, according to Keynes, could the government take to restore the equilibrium level of income that you determined in part (b)?

Answer 1

What is Marginal Propensity to consume?

MPC is the metric that quantifies the proportion of additional income that an individual consumes. For instance, if an earning of household increases by 100 extra dollar of disposable income, and the marginal propensity to consume is 0.70, then out of extra 100 dollar, the household will spend 70 dollars and save 30 dollars.

(a)

(b) At Equilibrium Level of Income,

Aggregate Supply(AS) or Income= Aggregate Demand  or Consumption(C) + Investment(I)+Government(G)+Net Exports(NX)

At National Income of $300, Aggregate Supply=Aggregate Demand

or 300=260+40

(c) Since Investment has declined by $20, So new facts and figures are as follows:

Income(Y) in $	Consumption(C) in $	Saving (S) in $	Investment (I) in $
0	20	-20	20
100	100	0	20
200	180	20	20
300	260	40	20
400	340	60	20

C(1) New Equilibrium Income

As Investment decreased by $20, new equilibrium income decreased from $300 to $200.

C (2) Calculation of Multiplier

= 5

Therefore Multiplier is equal to 5.

C(3) Why an increase in the unemployment rate would be associated with the decline in national income?

National income=Consumption + Saving=Aggregate Supply=Output

In other words, National income is nothing but output of a country.

If Output declines, it means there is low level of output. Low level of output is achieved by employing low number of people. If low number of people are employed, it means there is high level of unemployment or in other words unemployment level has increased.

(d) Strategy suggested by John Maynard Keynes to restore equilibrium after National Income has declined

If the equilibrium level of National Income has to be restored or in other words Aggregate Demand has to be increased, following steps should be taken:

Since the economy is in recession, so Tax rate should be decreased by Government, so people can take loan and start investing. Moreover, Government Expenditure should be increased.