Question

Suppose that the economy is in a long-run equilibrium at a price level of 100 and full-employment real GDP of $500 billion. An expansion occurs resulting from a $100 billion increase in aggregate demand. In order to restore the economy to full employment given a MPC of 0.80, government purchases would need to: Multiple choice question.

Answer 1

Government purchases would need to: decrease by $20 billion.

What is Marginal Propensity to Consume ?

Marginal Propensity to Consume (MPC) measures the proportionate rise in the consumption with increase in income or we can say it measures the proportion of extra pay that is spent on consumption of goods and services rather than saving it.

Marginal Propensity to Consume or MPC is dependent on the income level. It may vary with the income levels and it can be seen that the MPC is lower at higher income levels. MPC can be calculated by determining the change in consumption divided by the change in income.

MPC is represented by the consumption line, which is a sloped line that is formed when change in consumption is plotted on the vertical y-axis with change in income on the horizontal x-axis.

This can be illustrated from the following formula.

k = 1/ 1- MPC

Where k = Multiplier effect

MPC = Marginal Propensity to Consume

How many Types of MPC?

MPC can be classified into three types, which are

1. MPC more/greater than 1.

2. MPC equal to 1.

3. MPC less than 1.

Thus , we conclude that the amount of government purchases would have to be decreased by $20 billion.

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