Question

Suppose economists observe that an increase in government spending of $5 billion raises the real aggregate output level by $20 billion. (a) In the absence of the crowding out effect, what would the numerical value of marginal 1. propensity to consume (MPC)? (b) Now suppose the crowding-out effect also comes to play.Should the new numerical value of marginal propensity to consume (MPC) be larger or smaller than that of your answer in part (a)? Explain. (Hint: the multiplier effect and the crowding-out effect always works in the opposite direction.)

Answer 1

(a)

Multiplier = Increase in output / Increase in government spending = $20 billion / $5 billion = 4

If MPC be equal to c, then

Multiplier = 1 / (1 - c)

1 / (1 - c) = 4

4 - 4c = 1

4c = 3

c = 0.75

(b)

Let MPC after taking crowding-out effect into consideration be c1. Since crowding out effect decreases output, multiplier effect with crowding-out must be lower than the multiplier effect without crowding out.

[1 / (1 - c1)] < [1 / (1 - c)]

(1 - c1) > (1 - c)

- c1 > - c

c1 < c

Therefore, numerical value of MPC considering crowding-out effect is smaller.