Question

Consider a hypothetical closed economy in which households spend $0.70 of each additional dollar they earn and save the remaining $0.30. The marginal propensity to consume (MPC) for this economy is , and the spending multiplier for this economy is . Suppose the government in this economy decides to decrease government purchases by $300 billion. The decrease in government purchases will _______

Answer 1

Answer:

1. 0.7

2. 3.3

3. -$210

Explanation:

1. The marginal propensity to consume refers to the amount that is spent on consumption for each of the extra income earned. Therefore, the marginal propensity to consume (MPC) is equal to 0.7.

2. The multiplier is calculated as follows:

Multiplier = 1 ÷ (1 - MPC)

                = 1 ÷ (1 - 0.7)

                = 3.33

3. A reduction in the government purchases by $300 billion then this will reduce the income level of the consumers and change the consumption level as follows:

= Change in government purchases × MPC

= $300 billion × 0.7

= -$210