Consider a hypothetical economy where there are no taxes and no foreign trade an

Question

Consider a hypothetical economy where there are no taxes and no foreign trade and households spend $0.60 of each additional dollar they earn and save the remaining $0.40. The marginal propensity to consume (MPC) for this economy is _____, and themultiplier for this economy is _____. (Hint: You can ignore the impact of changes in the price level.)

Suppose investment spending in this economy decreases by $200 billion. The increase in investment will lead to an increase in income, generating an increase in consumption that increases income yet again, and so on. Fill in the following table to show the impact of the change in investment spending on the first two rounds of consumption spending and, eventually, on total output and income.

In reality, households will not simply split an increase in income between saving and consumptino of domestic output. A fractino of the additional income will go toward the payment of taxes, and a fraction will go to purchases of foreign goods (imports). Accounting for the effects of taxes and imports will _______ (reduce/increase) the multiplier effect you found earlier.

Now suppose that households in this economy allocate each additional dollar of income in the following way. Households continue to save $0.40 of each additional dollar income; however they now pay $0.05 in taxes on each additional dollar of income, and they now spend $0.05 of each additional dollar on imported goods. The remaining fraction of each additional dollar goes toward consumption of domestically produced output.

In this case, the fraction of an additional dollar of income that is NOT spent on domestic output is equal to _____. Taking the impact of taxes and imports into consideration, the multiplier for this economy is______.

Explanation / Answer

MPC = 0.6

Multiplier = 1/(1-MPC) = 1 / 0.4 = 2.5

First Change in consumption = -$200*0.6 = -$120

Second Change in consumption = -$200*0.6*0.6 = -$72

Total Change in Output = -$200 / (1-0.6) = -$500

Accounting for the effects of taxes and imports will reduce the multiplier effect you found earlier.

In this case, the fraction of an additional dollar of income that is NOT spent on domestic output is equal to 0.5.

Taking the impact of taxes and imports into consideration, the multiplier for this economy is 2.

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