Given the basic Keynesian model-as a starting point: Y = C + I + G C = a + b Yd

Question

Given the basic Keynesian model-as a starting point: Y = C + I + G C = a + b Yd I = f (i) I ? f (Y) ie., MPI* = 0 G = Go Tx = Txo * MPI to represent marginal propensity of invest (NOT import) Assuming an MPC of 0.8, which of the following is not true? (Points : 3)

a $10 billion increase in investment will increase income by $50 billion

a $5 billion tax cut will raise aggregate income by $25 billion

the MPS must be 0.2

a $20 billion increase in government spending will increase income by $100 billion

Explanation / Answer

Change in Y = Change in Investment / (1 - MPC)

Change in Y = 10 billion / (1 - 0.8) = 10 billion / 0.2 = $ 50 billion

So, a $ 10 billion increase in investment will increase income by $ 50 billion.

Change in Y = Change in Government spending / (1 - MPC)

Change in Y = 20 billion / (1 - 0.8) = 20 billion / 0.2 = 100 billion

So, a $20 billion increase in government spending will increase income by $100 billion

MPC + MPS = 1

0.8 + MPS = 1

MPS = 1 - 0.8 = 0.2

The MPS must be 0.2.

Change in Y = - MPC x Change in Taxes / (1 - MPC)

Change in Y = - 0.8 x - 5 billion / (1 - 0.8) = 4 billion/0.2 = $ 20 billion

So, a $5 billion tax cut will not raise aggregate income by $25 billion.

Answer is a $5 billion tax cut will raise aggregate income by $25 billion

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