Consider two closed economies that are identical except for their marginal prope
ID: 1200430 • Letter: C
Question
Consider two closed economies that are identical except for their marginal propensity to consume (MPC). Each economy is in equilibrium with real GDP and aggregate expenditure equal to $100 billion. The first economy's MPC is 0.5. Therefore, its initial aggregate expenditure line has a slope of 0.5 and psses through the point (100,100). The second economy's MPC is 0.75. Therefore, its initial aggregate expenditure lines has a slope of 0.75 and passes through the point (100,100). Now suppose there is an increase of $20 billion in investment in each economy. In the first economy (with MPC = 0.5), the $20 billion increase in investment causes aggregate output demanded to increase by_________. In the second economy (with MPC = 0.75), the $20 billion increase in investment causes aggregate output demanded to increase by _____________. Therefore, a higher MPC is associated with a ________multiplier.
Explanation / Answer
Multiplier = 1 / (1 - MPC)
In 1st economy, MPC = 0.5, So Multiplier = 1 / (1 - 0.5) = 1 / 0.5 = 2
In 2nd economy, MPC = 0.75, So Multiplier = 1 / (1 - 0.75) = 1 / 0.25 = 4
So, higher MPC is associated with a higher multiplier.
In 1st economy, $20 billion increase in investment causes aggregate demand to increase by $40 billion (= $20 billion x 2).
In 2nd economy, $20 billion increase in investment causes aggregate demand to increase by $80 billion (= $20 billion x 4).