Question

Where marginal propensity to consume is denoted as MPC, consider the following:
a. Assuming no crowding-out and MPC = 0.75, calculate the amount of government spending needed to bring this economy back to full-employment output.
b. Assuming no crowding-out and that $10 billion would be needed to bring this economy back to full-employment output, calculate the MPC in this economy.

Answer 1

Ans. Suppose full employment level of output is Y and current output is Y1 such that recessionary gap = Y - Y1

a) Multiplier = 1/(1-MPC) = 1/(1-0.75) = 4

Increase in output = multiplier * increase in government spending

=> Y - Y1 = 4 * increase in government spending

=> Increase in government spending = (Y - Y1)/4

b) Increase in output = multiplier *Increase in government spending

=> Y -Y1 = multiplier*10 billion

=> Multiplier = (Y - Y1)/10 billion

Multiplier = 1/(1-MPC) = (Y - Y1)/10 billion

=> MPC = 1 - [10 billion/ (Y - Y1)]

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