Question

Businesses in the nation of Islandia have been accumulating cash because they have a pessimistic outlook of the national economy. Recent changes in the economic outlook of Islandia have caused business leaders to begin to invest some of their accumulated cash. Suppose that businesses in the country invest a total of $20 billion of this cash. (a) What would be the maximum expected change in GDP if Islandia's marginal propensity toconsume (MPC) is 0.75? (b) Suppose that the recent economic outlook in the country of Mountainia has been the opposite.Businesses have postponed planned investments and have begun to accumulate cash. Ifbusinesses in Mountainia postpone $10 billion of their planned investments, what would be themaximum expected change in GDP if its marginal propensity to save (MPS) is 0.25?

Answer 1

Please see answer and explanation below.

Step-by-step explanation:

A. Since MPC is 0.75, therefore MPS would be 0.25 (i.e 1-MPC, 1-0.75)

The multiplier will now be(1/MPS) 1/0.25=4

It therefore follows that if investment increases $20billion, aggregate demand will also increase by $80billion(i.e 20 × 4). This means $60billion in consumption and $20billion in investment.

B. Since MPS is 0.25, Multiplier would therefore be 1/0.25(1/MPS) = 4

It therefore follows that if $10billion planned investments is postponed, the aggregate demand would decrease by $40billion( i.e 10 × 4 )

Meaning that there would be $30billion in consumption and $10billion in investment.