The multiplier effect of a change in government purchases Consider a hypothetica
ID: 1191818 • Letter: T
Question
The multiplier effect of a change in government purchases
Consider a hypothetical closed economy in which households spend $0.50 of each additional dollar they earn and save the remaining $0.50.
The marginal propensity to consume (MPC) for this economy is _________, and the multiplier for this economy is __________.
Suppose the government in this economy decides to decrease government purchases by $250 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to
. This decreases income yet again, causing a second change in consumption equal to
The total change in demand resulting from the initial change in government spending is
Explanation / Answer
Consider a hypothetical closed economy in which households spend $0.50 of each additional dollar they earn and save the remaining $0.50.
The marginal propensity to consume (MPC) for this economy is 0.5 , and the multiplier for this economy is 1/(1-0.5) = 2.
Suppose the government in this economy decides to decrease government purchases by $250 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to 0.5(250) = $125
This decreases income yet again, causing a second change in consumption equal to 0.5(125) = $62.50
The total change in demand resulting from the initial change in government spending is 2(250) = $500