Question

Consider a hypothetical economy. Households spend $0.60 of each additional dollar they earn and save the remaining $0.40. The spending multiplier for this economy is

.

Suppose investment in this economy increases by $250 billion. The increase in investment will lead to an increase in income, generating an increase in consumption that increases income yet again, and so on.

Fill in the following table to show the impact of the change in investment on the first two rounds of consumption spending and, eventually, on total spending and income.

Change in InvestmentChange in Investment	=  =	$250 billion$250 billion
First Change in ConsumptionFirst Change in Consumption	=  =	billion
Second Change in ConsumptionSecond Change in Consumption	=  =	billion
∙•		∙•
∙•		∙•
∙•		∙•
Total Change in SpendingTotal Change in Spending	=  =	billion

Now consider the impacts of a change in taxes. The tax multiplier in this question will be

, thus, if taxes increase by $100 billion then spending will change by

billion.

Answer 1

Answer:

(a) MPC = $0.6 / $1 = 0.6, and MPS = 1 - MPC = 1 - 0.6 = 0.4

Multiplier = 1/MPS = 1/0.4 = 2.5

(b)

(i) First change in consumption = $250 billion x 0.6 = $150 billion

(ii) Second change in consumption = $150 billion x 0.6 = $90 billion

(iii) Total change in spending = $250 billion x 2.5 = $625 billion

(c) Tax Multiplier = - MPC / MPS = - 0.6 / 0.4 = - 1.5

(d) If taxes increase by $100 billion, spending will change by -$150 billion [= $100 billion x (-1.5)].

Now consider the impacts of a change in taxes. The tax multiplier in this question will be -1.5, thus, if taxes increase by $100 billion then spending will change by -$150 billion.