My book says that if the MPC of disposable income is 0.6, and the marginal prope

Question

My book says that if the MPC of disposable income is 0.6, and the marginal propensity to invest is 0.2, and the Y multiplier is 5, then if the government reduces taxes by 150, the public will spend 0.6 * 150 , or 90, and Y will increase by 450.

I don’t understand this. Why don’t we say that the public will spend ((0.6+0.2) * 150), or 120, and Y will increase by 600. After all, when we talk about domestic investment, it's not only government that invests in the economy - people do too, right?

Please explain. Thank you.

Explanation / Answer

Investment is not subject to the multiplier effect. So, consumption increases by (0.6*150)=90. Income, Y, increases by (5*90=450) from consumption. Investment increases by (0.2*150)=30, but is not subject to the multiplier. So, income, y, increases by 480 in total. Traditionally, we consider investment only as a function of interest rate. However, you are right that investment should increase if a tax cut is given and there is a positive mpi.

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