Question

Consider three closed economies. In the first economy, households spend $0.50 of each additional dollar they earn and save the remaining $0.50. In the second economy, households are satiated, so they do not spend anything of each additional dollar they earn (they save it all). In the third economy, households spend a whole dollar of each additional dollar they earn (they don't save anything). Which of the following statements is correct?

a. In the second economy, the spending multiplier is greater than in the third economy. In the first economy, the spending multiplier is undefined
b. In the first economy, the spending multiplier is greater than in the second economy. In the third economy, the spending multiplier is undefined
c. In the third economy, the spending multiplier is greater than in the second economy. In the first economy, the spending multiplier is undefined
d. In the first economy, the spending multiplier is lower than in the second economy. In the third economy, the spending multiplier is undefined

Answer 1

b. In the first economy, the spending multiplier is greater than in the second economy. In the third economy, the spending multiplier is undefined

Step-by-step explanation:

This can be easily understood by going through some calculations in a spending multiplier formula.

WORKINGS

The formula for Spending Multiplier =
`(1)/(MPS)`

Spending Multiplier

Economy 1: Multiplier =
`(1)/(0.5)` = 2

Economy 2: Multiplier =
`(1)/(1)` = 1

Economy 3: Multiplier =
`(1)/(0)` = undefined

Note: MPS can be abbreviated as Marginal propensity to save

As we can see here economy 1 is 50% greater than economy 2 and economy 3 is undefined because they spend whole dollar they earn additionally.

On behalf of the above calculations, option B is a perfect match!