Question

In each of the following scenarios, what is the overall effect on equilibrium output?

a. Business optimism rises and, as a result, planned investment spending rises by $5 million. The marginal propensity to consume is 0.80. We can expect equilibrium output to  (Click to select)  increase  decrease  by $ million?

b. Household wealth rises and, as a result, autonomous consumption spending rises by $4 million. The marginal propensity to consume is 0.60. We can expect equilibrium output to  (Click to select)  increase  decrease  by $ million?

c. Taxes rise and, as a result, planned investment spending falls by $2 million and consumption spending falls by $4 million. The marginal propensity to consume is 0.75. We can expect equilibrium output to  (Click to select)  increase  decrease  by $ million?

Answer 1

a) Change in output = Change in investment spending x Multiplier

Change in output = 5 million x 1/(1 - MPC) = 5 million x 1/(1 - 0.8) = $ 25 million

So, equilibrium output increases by $ 25 million.

b) Change in output = Change in Consumption spending x 1/( 1- mpc) = 4 million x 1/(1 - 0.6)

Change in output = $ 10 million

So, equilibrium output increases by $ 10 million.

c) Change in output = - 2 million x 1/(1 - 0.75) - 4 million x 1/(1 - 0.75)

= - 8 million - 16 million = - $ 24 million

So, equilibrium output decreases by $ 24 million.