EXERCISE 2 Suppose that the Marginal Propensity to Consume (MPC) in an economy i

Question

EXERCISE 2 Suppose that the Marginal Propensity to Consume (MPC) in an economy is equa 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

Y = C + I

When the investment spending decreases by $50, the income also decreases by $50

1st round - Consumer spending decreases by = 50 x 0.75 = $ 37.5

2nd round - Consumer spending decreases by = 37.5 x 0.75 = $ 28.125

3rd round - Consumer spending decreases by = 28.125 x 0.75 = $ 21.094

4th round - Consumer spending decreases by = 21.094 x 0.75 = $ 15.82

Change in real income (decrease) = 50 / (1 - MPC) = 50 x 4 = $200 (decrease)

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