QNumber1. A small country with a marginal propensity to save of 0.30 and a margi

Question

QNumber1. A small country with a marginal propensity to save of 0.30 and a marginal propensity to import of 0.20 experiences an increase in exogenous spending of $3 million.

a. According to the spending multiplier, by how much will domestic product and income change?

b. What is the change in the country's imports?

c. If this country is large (rather than small), what effect will this have on foreign product and income? Explain.

d. Will the change in foreign product and income tend to counteract or reinforce the change in the first country's domestic product and income? Explain.

Explanation / Answer

Since marginal propensity to save of 0.30, marginal propensity to consume is 1 - 0.30 = 0.70 and a marginal propensity to import of 0.20. This makes import multiplier = 1/1-mpc + mpm = 1/1 - 0.70 + 0.20 = 2. The country experiences an increase in exogenous spending of $3 million.

a. According to the spending multiplier, domestic product and income change bu 3 million x multiplier or 3 million x 2 = $6 million.

b. The change in the country's imports is 0.20 x $6 million = $1.2 million.

c. If this country is large (rather than small), this increase in income will imply that its imports will be large and so it demand more foreign products. In that case the exports of foreign nation increases and so their income will also rise.

d. The change in foreign product and income will demand more of our exports and so our income rises once again. This will reinforce the change in the first country's domestic product and income because it experienced a rise in income at first.

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