Question

Consider a hypothetical economy. Households spend $0.90 of each additional dollar they earn and save the remaining $0.10. The spending multiplier for this economy is ___________. Suppose investment in this economy decreases by $200 billion. The decrease in investment will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on.

Answer 1

• Spending multiplier = 10
• Change in consumption = -$180 billion

Step-by-step explanation:

The spending multiplier is calculated by the formula:

= 1 / Marginal propensity to save

The marginal propensity to save is the proportion of every additional dollar that is saved which is this case is $0.10 which is 10%.

Spending multiplier is:

= 1 / 0.1

= 10

Change in consumption as a result of the decrease:

= -200 * marginal propensity to consume

= - 200 * 0.9

= -$180 billion