Question

Suppose the economy is in a recession and the president wants to stimulate production and create jobs. To do this, he has decided to increase government spending. Some of his economic advisors are suggesting the marginal propensity to consume (MPC) has a value of 0.9 and others are suggesting the value is 0.8. How will this difference in the value of the MPC affect the president’s decision regarding the dollar amount of the increase in government spending?

Answer 1

What is important here is essentially the value of the multiplier. The multiplier formula is given by K= 1/(1-c) where the c is the marginal propensity to consume. Now if the marginal propensity to consume is 0.8 then the multiplier will be smaller than if the marginal propensity to consume is 0.9. This will mean that in case the mpc is 0.8, the increase in government spending will have to be larger to have a larger dollar impact on the economy, as compared to a mpc of 0.9. The lower the marginal propensity to consume the smaller will be the multiplier and so the larger the increase in government spending that will be needed to bring about a larger dollar impact. At a 0.8 mpc a larger increase in government spending will be needed.