3. When there is a shift in autonomous expenditure, why is there a multiple expa

Question

3. When there is a shift in autonomous expenditure, why is there a multiple expansion of income and real GDP Trace the multiplier effect through the first four rounds when there is an increase in autonomous expenditure of $40 billion and the marginal propensity to consume is 0.75. 4. Answer the following questions: a. If aggregate expenditures falls by $5 million, and the MPC is 0.80, explain the process that will drive the economy to a new equilibrium level. b. What will be the final result of this initial change? Why does the aggregate demand (AD) curve slope downward? What could cause the AD curve to shift to the right? What impact would a rightward shift of the AD curve have on the economy? 5. 6. Discuss the differences between Keynesian and supply-side fiscal policies

Explanation / Answer

The consumption function is the functional relationship between aggregate consumption and disposable income. The consumption is divided into two parts one is autonomous or constant and other is induced or depends upon disposable income. The induced consumption is the amount of income which is consumed. It is given by MPC time disposable income. Graphically consumption function is the positively sloped straight line with slope equals to MPC.

The marginal propensity to consume (MPC) is the additional amount of consumption results from one additional unit of income. The marginal propensity to save (MPS) is the additional amount of savings results from one additional unit of income. There is two uses of disposable income, it either consumed or saved. Thus, if the income increases by $1, the part of it will be consumed and the other part will be saved. The part which will be consumed is given as MPC, thus the remaining part should give MPS.

In the economy every spending is someone else’s income. Then any increase in expenditure increases equal earning of another agent within the economy. That is if $1 is spent by a person it will generate $1 income for the seller. According to MPC, a fraction of $1 is consumed and the rest is saved. This seller being a consumer spends a fraction of this newly generated income to buy goods and services. This increases the income of the second seller. Then this 2nd person spends the fraction of the newly generated income again. This process continues infinite times until there is nothing left to spent.

This way the $1 increase in autonomous expenditure sets out multiple spending and generates multiple income. In other words, every dollar increase in income generates multiplier effect of rise in income. Hence, an increase in purchase increases the income in the economy by larger amount of the initial increase. The increase in income is the multipliers times of the initial increase in purchase.

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This way an initial increase in $40 billion spending increases income by $40 billion in first round. As the MPC is 0.75, 75% of the $40 billion is spent in second round. Then in second round $30 billion new income in generated. In third round 75% of $30 billion is spent and generates $22.5 billion income. In fourth round 75% of $22.5 billion is spent and generates $16.875 billion income. In fifth round 75% of $16.875 billion is spent and generates $12.65625 billion income.

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