Question

2. If the MPC were 0.9 and government increased spending by $100 billion. (a) How much spending would occur in the third cycle of the figure below? (b) How many spending rounds would occur before consumer spending increased by $300 billion? The third cycle there would be 81 billion of

Answer 1

a) In the first cycle / round, aggregate spending rises by full $100 billion. In the next cycle, consumption and thus, aggregate spending increase by MPC times the increase in income which is 0.9 x 100 = $90 billion. In the third cycle, consumption and thus, aggregate spending increase by MPC times the increase in income which is 0.9 x 90 = $81 billion. Hence spending will increase by $81 billion in third cycle

b) In the second round consumer spending rises by $90 billion. In the third round consumer spending rises by 0.9 x 90 = $81 billion. In the fourth round consumer spending rises by 0.9 x 81 = $72.9 billion. In the fifth round consumer spending rises by 0.9 x 72.9 = $66.339 billion. Cumulatively, consumer spending has increased by 90 + 81 + 72.9 + 66.339 = 313 billion approximately. Hence it requires five rounds before consumer spending rises by $300 billion.