Question

Use the following information below to answer the following question(s):

C = 800 + 0.65 YD
I = 750
G = 1500
T = 900


Refer to the information above. Which of the following events would cause an increase in the size of the multiplier?
Select one:
a. A reduction in government spending.
b. An increase in investment.
c. An increase in the propensity to consume.
d. An increase in the propensity to save.
e. A reduction in taxes.

Answer 1

From the identity C + I + G + X = Y, where X represents exports, we see that the size of the multiplier depends on the marginal propensities to consume (MPC), which equals the proportion of income spent on consumption out of disposable income (Y - T). MPC = C/ (Y - T). Since we don't know the values of Y and T yet, we can't say what event might affect the multiplier without knowing their effects on T and Y. Answer e is incorrect as it assumes that the change in T only affects the government budget balance, not net tax revenue. Moreover, it also incorrectly assumes that reducing taxes increases disposable income instead of just increasing private sector savings.