Suppose that the Marginal Propensity to Consume (MPC) in an economy is equal to

ID: 1130056 • Letter: S

Question

Suppose that the Marginal Propensity to Consume (MPC) in an economy is equal to 0.75 and that you are told that investment spending descreases this year by $50. 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

Solution:

Increase in investment spending

-50

Plus: 2nd round: Increase in consumer spending

MPC * -50 = -37.50

Plus: 3rd round: Increase in consumer spending

(MPC)[(MPC) * (-50)] = -28.125

Plus: 4th round: Increase in consumer spending

MPC(MPC)[(MPC) * (-50)] =-21.094

Total Increase in real GDP

[1/(1 MPC)] * (-50) = -200

Multiplier =1/(1 -MPC) = 4

Because investment spending has reduced by -$50, thus the overall change in real GDP must be a reducd of 4 * (-$50) or -$200