Question

Suppose economists observe that an increase in government spending of $15 billion raises the total demand for goods and services by $60 billion. If these economists ignore the possibility of crowding out, they would estimate the marginal propensity to consume (MPC) to be .

a. 1/4
b. 3/4
c. 1/4
d. 4

Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

Answer 1

Option B, 3/4 is correct answer.

Step-by-step explanation:

Given an increase in government spending = $15 billion.

The increase in total demand for goods and services = $60 billion.

Firs calculate the expenditure multiplier by dividing the increase in demand for goods and services with an increase in government spending.

Expenditure multiplier = 60 / 15 = 4

Now find the MPC with the help of expenditure multiplier.

`\text{ Expenditure mulitplier} = (1)/(1 - MPC) \\4 = (1)/(1 - MPC) \\4 – 4MPC = 1 \\MPC = (3)/(4)`

Thus, option B is correct.

Now solve for the second case, the allow for crowding out.

If there is crowding out that means multiplier will be higher than initial multiplier.

`frac{1}{1 - MPC} > 4 \\1 > 4 – 4MPC \\MPC > (3)/(4)`

Thus, the new MPC will be greater than the previous one.