Question

Assume an economy with no foreign sector, a marginal propensity to save out of disposable income equal to 0.2, and a marginal income tax rate of t = 0.25. If autonomous saving decreases by 300, which of the following is true? The answer is A. Total consumption will increase by 750. Could you show how to get this?

Answer 1

We have the following information

Marginal propensity to save (MPS) = 0.2

Marginal propensity to consume (MPC) = 1 – MPS = 1 – 0.2 = 0.8

Marginal income tax rate (t) = 0.25

Value of multiplier = 1/[1 – MPC + (MPC × Marginal Tax Rate)]

Value of multiplier = 1/[1 – 0.8 + (0.8 × 0.25)]

Value of multiplier = 1/(1 – 0.8 + 0.2)

Value of multiplier = 1/0.4

Value of Multiplier = 2.5

Since decrease in savings results in increase in consumption so 300 decrease in savings will cause the consumption to increase by 2.5 × 300 = 750.