Question

3. The multiplier and the MPC

Consider two closed economies that are identical except for their marginal propensity to consume (MPC). Each economy is currently in equilibrium with real GDP and total expenditure equal to $100 billion, as shown by the black points on the following two graphs. Neither economy has taxes that change with income. The grey lines show the 45-degree line on each graph.

The first economy's MPC is 0.5. Therefore, its initial total expenditure line has a slope of 0.5 and passes through the point (100, 100).

The second economy's MPC is 0.70. Therefore, its initial total expenditure line has a slope of 0.70 and passes through the point (100, 100).

Now, suppose there is an increase of $30 billion in investment in each economy.

Place a green line (triangle symbol) on each of the previous graphs to indicate the new total expenditure line for each economy. Then place a black point (plus symbol) on each graph showing the new level of equilibrium output. (Hint: You can see the slope and vertical axis intercept of a line on the graph by selecting it.)

In the first economy (with MPC = 0.5), the $30 billion increase in investment causes equilibrium output to increase bybillion. In the second economy (with MPC = 0.70), the $30 billion increase in investment causes equilibrium output to increase bybillion. Therefore, a lower MPC is associated with ahigher   multiplier.

Now, confirm your graphical analysis algebraically using the oversimplified multiplier formula:

Multiplier

=

11−MPC

For the first economy, with an MPC of 0.5, the effect of the $30 billion increase in investment is as follows:

Change in Equilibrium Output

=

Change in Total Expenditure

×

Multiplier

	=

×

	=

×

	=

Using the same method, the multiplier for the second economy is   .

Answer 1