Question

Consider two closed economies that are identical except for their marginal propensity to consume (MPC). Each economy is currently in equilibrium with real income and planned 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 planned expenditure line has a slope of 0.5 and passes through the point (100, 100).

The second economy's MPC is 0.75. Therefore, its initial planned expenditure line has a slope of 0.75 and passes through the point (100, 100).

Now, suppose there is a decrease of $20 billion in planned investment in each economy.

Place a green line (triangle symbol) on each of the previous graphs to indicate the new planned expenditure line for each economy. Then place a black point (plus symbol) on each graph showing the new level of equilibrium income. (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 $20 billion decrease in planned investment causes equilibrium income to decrease bybillion. In the second economy (with MPC = 0.75), the $20 billion decrease in planned investment causes equilibrium income to decrease by

billion. Therefore, a lower MPC is associated with a multiplier.

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

MultiplierMultiplier

=  =

11−MPC11−MPC For the first economy with an MPC of 0.5, the effect of the $20 billion decrease in planned investment becomes the following: Change in Equilibrium Real IncomeChange in Equilibrium Real Income=  =Change in Planned ExpenditureChange in Planned Expenditure×  ×MultiplierMultiplier=  =×  ×=  =×  ×=  = Using the same method, the multiplier for thesecond economy is .

Answer 1

The first economy's MPC is 0.5

The second economy's MPC is 0.75.

In the first economy (MPC = 0.5), the $20 billion decrease in planned investment causes equilibrium income to decrease by $40 billion.

In the first economy (MPC = 0.5), the $20 billion decrease in planned investment causes equilibrium income to decrease by $80 billion.

Therefore, a lower MPC is associated with a Lower Multiplier.

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