Question

1. In a closed economy, the marginal propensity to save increases and tax rates remain unchanged. What effect will this have on the marginal propensity to consume and on the multiplier? Assume that the MPS increases from 1/3 to 1/4 and tax rate is 0.20.

Answer 1

Answer :

In a closed economy there is no exports and imports. The only two leakages are saving and taxation and the two injections are investment and government spending.

The formula for the multiplier will be 1/marginal rate of withdrawal

i.e. 1/(MPS + MRT)

As the marginal propensity to save (MPS) = 0.3 and the marginal rate of tax (MRT) = 0.2

Therefore the multiplier = 1 / (0.3 + 0.2) = 2

If the marginal propensity of save to increases to 0.4 and the marginal rate of tax remains the same at 0.2

Therefore the multiplier = 1/ (0.4+0.2) = 1.67

I.e. the multiplier falls when the marginal rate of leakage increases.