Question

Suppose that the marginal propensity to consume if.6 and that there is an increase in government expenditure of 5. a) According to the Keynesian cross model, what is the change in output that results from this policy change? b) Describe the graphical impact that this change will have on the Keynesian cross model c) Why is the change in output different from the change in government expenditure? Explain how this process works intuitively.

Answer 1

We have the following information

Marginal propensity to consume (MPC) = 0.6

Increase in government spending: ΔG = 5

Spending Multiplier = 1/(1 – MPC) = 1/(1 – 0.6) = 1/0.4 = 2.5

Change in the output: ΔY = ΔG × Spending Multiplier

ΔY = 5 × 2.5

ΔY = 12.5

So, the output will increase by 12.5

This is reflected in the following diagram by the upward shift of the aggregate expenditure curve from AE1 to AE2.

Aggregate Expenditure AEZ 1. -AE, E Juso O GOP

One can see that the change in the output is different from the change in the income. In fact, increase in output is higher than the increase in the government spending. This happens due to the presence of spending multiplier. When government spending increased initially it increased the aggregate demand and output in the economy directly by the amount of G increase, and thereafter through the multiplier effect as consumption and income levels rise. The increase in income due to increase in government spending stimulates consumption which cause further increase in demand and income, which again causes the consumption to increase and so forth. This process continues with each consecutive increase in consumption being less than the previous one as MPC is less than one.

It is because of this that the change in output is different from change in G.