Question

Suppose that an initial $10 billion increase in investment spending expands GDP by $10 billion in the first round of the multiplier process. If GDP and consumption both rise by $6 billion in the second round of the process, what is the MPC in this economy? What is the size of the multiplier? If, instead, GDP and consumption both rose by $8 billion in the second round, what would have been the size of the multiplier?

Answer 1

If GDP and consumption both rise by $6 billion in the second round of the process, what is the MPC in this economy?

• MPC = 0.8

What is the size of the multiplier?

• multiplier = 2.5

If, instead, GDP and consumption both rose by $8 billion in the second round, what would have been the size of the multiplier?

• multiplier = 5

Explanation:

Since the change in consumption is $6 billion, and the initial expansion in investment was $10 billion, the marginal propensity to consume (MPC) = expansion in consumption / initial expansion = $6 / $10 = 0.6

the economy's multiplier = 1 / (1 - MPC) = 1 / (1 - 0.6) = 1 / 0.4 = 2.5

If both the economy and the GPD had expanded by $8 billion, the MPC = $8 / $10 = 0.8, so the economy's multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

Another way to determine the multiplier = 1 / MPS (marginal propensity to save), since MPS = 1 - MPC