Question

The US has just entered a major recession. Please describe what will happen as the US Government uses Expansionary Fiscal Policy to aid the economy. Assume that the marginal propensity to expend is 0.9 and therefore the multiplier is 10. According to the multiplier model, an increase in autonomous consumption of 200 would raise the equilibrium level of income by 2000. 1) Explain how the multiplier process amplifies the initial shift in autonomous expenditures. 2) Had the MPE only been .5, what would have needed to happen to get the economy back to equilibrim?

Answer 1

1)

Through multiplier process, initial rise in income leads to the multiple rise in final income. Value of multiplier depends upon the Marginal Propensity to consume. Higher value of MPC would cause higher value of multiplier. Initial injection of expenditure causes rise in income through subsequent rounds.

Increase in autonomous Expenditure - Expenditure by one entity is income of another entity - Further rise in Income of entity increase expenditure of one individual - Hence expenditure again causes rise in income.

2)

New Multiplier Value = 1/1-MPC

= 1/0.5

= 2

Autonomous expenditure equal to $ 1,000 would increase income by $ 2,000 (1,000*2)