Question

Assume the following values: Marginal Propensity to Consume b = 0.8; Autonomous Consumption a = 200; Investment Spending I = 250. There is no government spending.

a) For a consumption function C = a + bY, what is the equilibrium value for income Y in the economy? (The value at which planned aggregate expenditure and planned output coincide.)

b) What changes when Investment Spending increases to 300? When it drops to 225?

c) What effect can you observe in the change in Y that follows changes in I?

d) How high is the Marginal Propensity to Save in this case?

e) If you add the government sector, with expenditure G = 250, what is the new equilibrium income? (For I = 250)

f) What happens when the Marginal Propensity to Save increases? How does equilibrium output change?

Answer 1

(a) C = 200 + 0.8Y

In equilibrium, Y = C + I

Y = 200 + 0.8Y + 250

(1 - 0.8)Y = 450

0.2Y = 450

Y = 2,250

(b) When investment demand increases (decreases), equilibrium output increases (decreases).

(c) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

When I = 300 (Increase of 300 - 250 = 50), Increase in Y = 50 x 5 = 250

When I = 225 (Decrease of 250 - 225 = 25), Decrease in Y = 25 x 5 = 125

(d) MPS = 1 - MPC = 1 - 0.8 = 0.2

(e) When G = 250, Autonomous spending increases by 250.

Increase in Y = 250 x 5 = 1,250

New value of Y = 2,250 + 1,250 = 3,500

(f) Since MPS = 1 - MPC, Spending multiplier = 1 / MPS

As MPS increases, Multiplier decreases. Therefore increase (decrease) in output for a given increase (decrease) in autonomous spending is lower.