Question

Suppose that an initial $10 billion increase in investment spending expands GDP by $10 billion in the first round of the multiplier process. Also assume that GDP and consumption both rise by $6 billion in the second round of the process.

Instructions: Round your answers to 1 decimal place.

a. What is the MPC in this economy?

b. What is the size of the multiplier?

c. If, instead, GDP and consumption both rose by $8 billion in the second round, what would have been the size of the multiplier?

Answer 1

Solution:

We are given that a $10 billion increase in spending causes a $6 billion increase in GDP and consumption in the second round of the process. This means that of the $10 billion spent, $4 billion was saved and the remaining $6 billion were used for more consumption. In other words, the marginal propensity to consume ( MPC ) is .6, as 60% of the change in income of $10 billion was used for consumption.
The multiplier is defined as Multiplier = .Since we found that the MPC is 6, we can substitute 6 into expression to get the multiplier.

  

  

If instead of $6 billion, consumption and GDP rose by $8 billion in the second round, then we see that the MPC will be .8 instead. This is because a MPC of .8 gives us that a $10 billion increase in income will cause a $8 increase in consumption (80% of the change in income is used for consumption). Hence, we can use the new MPC of .8 to find the new multiplier.