Question

Consider a hypothetical economy. Households spend $0.60 of each additional dollar they earn and save the remaining $0.40. The multiplier for this economy is. Suppose government purchases, G G , in this economy increase by $250 billion. The increase in G G will lead to an increase in income, generating an increase in consumption that increases income yet again, and so on. Fill in the following table to show the impact of the change in G G on the first two rounds of consumption spending and, eventually, on national income. Note: Use negative signs if numbers are negative. Change in G Change in G = = $250 billion $250 billion First Change in Consumption First Change in Consumption = = billion Second Change in Consumption Second Change in Consumption = = billion • • • • • • • • • • • • Total Change in Income Total Change in Income = = billion Now consider the impact of a similar change in taxes. The (absolute value) of the tax multiplier in this question will be; thus, if taxes change by $250 billion, spending will change bybillion. Based on your results, this Keynesian model predicts that a change in will have the larger effect on income, given the initial change in planned expenditures is of the same magnitude.

Answer 1

(a) MPC = $0.6 / $1 = 0.6, and MPS = 1 - MPC = 1 - 0.6 = 0.4

Multiplier = 1/MPS = 1/0.4 = 2.50

(b)

(i) First change in consumption = $250 billion x 0.6 = $150 billion

(ii) Second change in consumption = $150 billion x 0.6 = $90 billion

(iii) Total change in income = $250 billion x 2.5 = $625 billion

(c) Absolute value of Tax multiplier = MPC / MPS = 0.6 / 0.4 = 1.50

(d) If taxes change by $250 billion, spending will change by $250 billion x 1.5 = $375 Billion

(e) A change in government spending will have the larger effect on income.