Consider a standard Keynesian economy with perfectly sticky prices. Suppose ther

Question

Consider a standard Keynesian economy with perfectly sticky prices. Suppose there is a decrease in MPC (b drops from 0.8 to 0.5). How does this affect the responsiveness of output to an exogenous change in government spending? A. It increases the responsiveness of output to a change in government spending. B. It could decrease or increase the responsiveness of output depending on other parameter values C. It decreases the responsiveness of output to a change in government spending D. It has no effect on the responsiveness of output to a change in government spend- ing.

Explanation / Answer

Correct option is (C).

Spending multiplier = 1 / (1 - MPC). Therefore, as MPC falls, (1 - MPC) rises and therefore, Spending Multiplier decreases. Since spending multiplier measures the ratio of change in output to a change in exogenous spending, a decrease in value of the multiplier means lower responsiveness of output to a change in government spending.

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