Question

The multiplier effect

Consider a hypothetical economy where there are no taxes and no foreign trade, and households spend $0.90 of each additional dollar they earn and save the remaining $0.10. The marginal propensity to consume (MPC) for this economy is ; the marginal propensity to save (MPS) for this economy is ; and the multiplier for this economy is

Suppose investment spending in this economy decreases by $150 billion. The decrease in investment will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on.

Fill in the following table to show the impact of the change in investment spending on the first two rounds of consumption spending and, eventually, on total output and income.

Hint: Be sure to enter a negative sign in front of the number if there is a decrease in consumption.

Answer 1

You did not provide the table, so I'm doing it manually as follows.

(1)

MPC = $0.9 / $1 = 0.90

MPS = $0.1 / $1 = 0.10

(2) When investment decreases by $150 billion: Round 1

Change in income ($ billion) = - 150

Change in consumption ($ billion) = - 150 x 0.9 = - 135

(3) When investment decreases by $150 billion: Round 2

Change in income ($ billion) = - 135

Change in consumption ($ billion) = - 135 x 0.9 = - 121.5

(4) After first 2 rounds,

Total change in consumption ($ billion) = - 135 - 121.5 = - 256.5

Total change in income ($ billion) = - 150 - 135 = - 285

(5) After all rounds of consumption-income are completed,

Total change in income and output ($ billion) = Change in investment / MPS = - 150 / 0.1 = - 1,500