EXERCISE 1 Suppose that the Marginal Propensity to Save (MPS) in an economy is 0

Question

EXERCISE 1 Suppose that the Marginal Propensity to Save (MPS) in an economy is 0.2. Furthermore, suppose that you are told that the level of investment spending increases by $200 during this year. Trace out the total increase in real GDP showing the increase in consumer spending for at least the second, third, and fourth rounds of spending. Provide the numerical value of the increase in consumer spending for each of these rounds as well as the total increase in real GDP. Assume that in this economy there is no government sector, no taxes, no transfers, and the aggregate price level and the interest rate are fixed EXERCISE 2 Suppose that the Marginal Propensity to Consume (MPC) in an economy is equal to 0.75 and that you are told that investment spending decreases this year by S50. You are asked to calculate the change in consumer spending for the second round, third round, and fourth round, and in addition, you are asked to calculate the change in real income due to this change in investment spending. Assume that in this economy there is no government sector no taxes, no transfers, and the aggregate price level and the interest rate are fixed

Explanation / Answer

(Exercise - 1)

MPS = 0.2, therefore MPC = 1 - MPS = 1 - 0.2 = 0.8

When investment increases by $200:

In round 1, real GDP increases by $200 & Consumption increases by ($200 x 0.8) = $160

In round 2, real GDP increases by $160 & Consumption increases by ($160 x 0.8) = $128

In round 3, real GDP increases by $128 & Consumption increases by ($128 x 0.8) = $102.4

In round 4, real GDP increases by $102.4 & Consumption increases by ($102.4 x 0.8) = $81.92

Spending multiplier = 1 / MPS = 1 / 0.2 = 5

Therefore, total increase in real GDP = $200 x 5 = $1,000

NOTE: As per Chegg answering guidelines, 1st question is answered.

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