Whenever there in change in spending, real GDP will change by a multiple of the

Question

Whenever there in change in spending, real GDP will change by a multiple of the initial change in spending. I sing the circular flow model, explain how the multiplier works as it relates to equilibrium real GDP. (5) (b) Calculate the MPC, MPS and multiplier when the consumers save 10% of each extra dollar of income? (3) (c) By how much will real GDP change if the federal government increased their level of spending (no change in taxes) by SS billion w hen MPC is.80? Will this change be an increase or decrease in real GDP? Why would this policy change is enacted? (4) (d) By how much will GDP change if the federal government increased tax receipts (no change nin spending) by S8 billion when MPC is.80? Will this change be an increase or decrease in real GDP? Why would this policy change is enacted? (3) (e) If the total unemployment rate is 4.5degree o and the NRU is 5%, use Okum's law to calculate the size of the gapbetween equilibrium and full-employment real GDP. Indicate if the gap is inflationary or recessionary. (2) (f) If the federal government w anted to close the gap identified in(e) above, woulda change in spending or change in taxes close the gap identified in (e)with less impact on the deficit? Why? (3)

Explanation / Answer

Answer.

Lets take an example to understand the multiplier. lets assume MPC=0.8. Spending increases by 100 by assuming a new college is built. Income of construction workers increase by 100 and they will spend 80% or 80Rs. This spends will be on food, shopping or movies which increases the income of others by 80. They in turn spend 80% or 64 Rs. This 64 becomes income of others in society and then they 80% and hence the process continues.

When all the effects are added, total income will increase by 500 because the value of the output multiplier is equal to 1/(1-0.8) = 5. Hence the initial increase of 100 led to increase of 500.

b. Consumers save 10% of the additional income. Thus MPS= 0.1 and MPC=1-MPS. Hence MPC= 0.9

Multiplier= 1/MPS = 1/0.1 = 10.

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