Question

Imagine a hypothetical economy that has no foreign trade and is initially in equilibrium. Assume that the marginal propensity to consume (MPC) in this economy is 0.75, the marginal propensity to import (MPI) is 0.10, and there are no taxes. Then a decline in government spending by $60 million will result in a total reduction in equilibrium income of:

Answer 1

Hence, the correct answer is $ 171.43 million

Step-by-step explanation:

Multiplier = 1/(1 - MPC(1 - t) + MPI)

where MPC = Marginal propensity to consume = 0.75, MPI = Marginal propensity to import = 0.10, t = tax rate and here tax rate = 0.

Thus Multiplier = 1/(1 - 0.75(1 - 0) + 0.10) = 1/0.35 = 20/7

Interpretation of this multiplier :

$1 increase in autonomous expenditure will result in increase in equilibrium income by $(20/7) or $1 decrease in autonomous expenditure will result in decrease in equilibrium income by $(20/7).

As government spending is considered as autonomous(i.e. independent of Income) thus decrease in $60 million of government spending will result in decrease in equilibrium income by (20/7)* 60 million = 171.43 million.