Question

Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion. 1. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be? Round your answer to the nearest one hundredth. 2. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

Answer 1

Given that an increase in government spending is \(\$ 10\) billion and the total demand for goods and services is \(\$ 30\) billion.

Calculate Multiplier:

$$ \begin{aligned} \text { Multiplier } &=\frac{\text { Demand for gooods and services }}{\text { Government Spending }} \\ &=\frac{30}{10} \\ &=3 \end{aligned} $$

Calculate \(M P C:\)

$$ \begin{aligned} \text { Multiplier } &=\frac{1}{1-M P C} \\ 1-M P C(\text { Multiplier }) &=1 \\ (1-M P C) 3 &=1 \\ 3-3 M P C &=1 \\ 3 M P C &=2 \\ M P C &=\frac{2}{3} \end{aligned} $$

Therefore, the value of Marginal Propensity to Consume is \(\frac{2}{3}\)

If the economists allow for crowding out then the new estimate of \(M P C\) would be larger than the initial one.