Question

Monetary Policy and Fiscal Policy have in the past had relatively large impacts on the economy because of the multiplier effect. The multiplier comes from the fact that your spending turns into income for someone else, who then in turn spends some of that money. The multiplier is calculated using the simple formula 1/(1-MPC) where MPC is the marginal propensity to consumer (how much of each additional dollar in income is spent. Historically, this value has been 0.9, that is people spend nearly 90 cents of each additional dollar in income. During the pandemic, some economists think this number may be closer to 0.2. (a) Consider the $500 billion sent to individuals in the form of checks. How large of an effect would this have been thought to have had in the past (i.e. MPC = 0.8)? (b) How large of an effect should the $500 billion have in a world in which there is massive uncertainty and quarantines (i.e. MPC = 0.2)? (c) What does this suggest about the likely efficacy of fiscal and monetary policy in alleviating the current crisis?

Answer 1

1. Mpc=0.8 then Multiplier=1/1-Mpc=1/1-0.8=5

when $500 billion is sent then it will increase the equilibrium level of income by 2500billion

b. MPC=0.2 then multiplier=1/1-0.2=1/0.8=1.25

Thus Equilibrium level of income increases by 1.25*500=625billion

fiscal and monetary policy are more effective when MPC is higher and people spend  more of their income. During pandemic situation, due to lower mpc, fiscal and monetary policy will be less effective.