Question

True or false and explain

1. The paradox of thrift occurs when an increase in saving leads to an increase in investment spending.

2. Suppose that the economy of Kennyland has an MPC of 0.8and an MPIM of 0.2. Currently, real GDP is $1800 and full-employment GDP is $2000. In this example, an increase in government spending of $40 will eliminate the GDP gap.

Answer 1

Question 1

Paradox of thrift states that as individual households' increases their savings, they tends to reduce their consumption. This reduction in consumption leads to fall in aggregate demand in the economy which in result leads to fall in total income in the economy which in result leads to fall in aggregate savings in the economy. As savings acts as source of investment, there is decline in investment as well.

Thus,

The given statement is false.

Question 2

Current real GDP = $1,800

Full employment GDP = $2,000

GDP gap = Full employment GDP - Current real GDP = $2,000 - $1,800 = $200

MPC = 0.8

MPS = 1 - MPC = 1 - 0.8 = 0.2

MPIM = 0.2

Calculate the Multiplier -

Multiplier = 1/(MPS + MPIM) = 1/(0.2 + 0.2) = 1/0.4 = 2.5

Calculate the increase in government spending required -

Increase in government spending = GDP gap/Multiplier = $200/2.5 = $80

Thus,

An increase in government spending of $80 will eliminate the GDP gap.

Hence, the given statement is False.