Consider a closed economy with the following consumption function: C = 250 + 0.7

Question

Consider a closed economy with the following consumption function: C = 250 + 0.75(Y - T) What is the marginal propensity to consume for this economy? What is the simple spending multiplier for this economy (i.e. - delta Y*/delta Y^d_0)? Assuming that investment (I) and taxes (T) are unaffected by the change, how would autonomous expenditure (Y^d_0) be affected (up or down, and by how much) by a 250 unit increase in government purchases? How would the equilibrium value of income be affected? Assuming that investment (I) and government purchases (G) are unaffected by the change, how would autonomous expenditure (Y^d_0) be affected (up or down, and by how much) by a 250 unit increase in taxes (T)? How would the equilibrium value of income be affected? What would be your answers to (c) and (d) if the consumption function were, instead C = 250 + 0.90(Y - T)?

Explanation / Answer

1) MPC = 0.75

2) Multiplier : 1/1-MPC = 4

3) Government spending and equilibrium level of income are positively related. Increase in government spending will increase aggregate expenditure and rise income as well.

If MPC = .90 then multiplier will be 1/0.1 = 10.

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