Chapter 19: The Keynesian Model in Action: Aplia Homework Attempts: 4. The multi

Question

Chapter 19: The Keynesian Model in Action: Aplia Homework Attempts: 4. The multiplier effect Average: /3 Consider a hypothetical economy. Households spend $0.60 of each additional dollar they earn and save the remaining $0.40. The spending multiplier for this economy is Suppose investment in this economy increases by $250 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 on the first two rounds of consumption spending and, eventually, on total spending and income. Change in Investment-$250 billion First Change in Consumption-S Second Change in Consumption billion billion Total Change in Spending-S billion Now consider the impacts of a change in taxes. The tax multiplier in this question will be spending will change by S thus, if taxes increase by $100 billion then billion

Explanation / Answer

(1) MPC = $0.6 / $1 = 0.6 and MPS = $0.4 / $1 = 0.4

Spending multiplier = 1/MPS = 1/0.4 = 2.5

(2) When investment incraeses by $250 billion,

First change in consumption = $150 billion [= $250 billion x 0.6]

Second change in consumption = $90 billion [= $150 billion x 0.6]

Total change in spending = $625 billion [= $250 billion x 2.5]

(3) Tax multiplier = - MPC / MPS = -0.6 / 0.4 = -1.5

(4) If taxes increase by $100 billion, spending will change by -$150 billion [= $100 billion x (-1.5)].

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