Question

Consider a hypothetical closed economy in which households spend $0.70 of each additional dollar they earn and save the remaining $0.30. The marginal propensity to consume (MPC) for this economy is:
A) .3

B) .7

C) 1

D) 1.43

E) 3.33

and the oversimplified multiplier for this economy is:

A) .3

B) .7

C) 1

D) 1.43

E) 3.33

Suppose the government in this economy decides to decrease government purchases by $300 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to:

A) -$1,000 billion

B) -$90 billion

C) -$210 billion

D) -$500 billion

E) -$105 billion

This decreases income yet again, causing a second change in consumption equal to:

A) -$1,000 billion

B) -$90 billion

C) -$210 billion

D) -$500 billion

E) -$107 billion

The total change in demand resulting from the initial change in government spending is:

A) -$0.6 trillion

B) -$0.7 trillion

C) -$2.7 trillion

D) -$1 trillion

Answer 1

(a) Marginal propensity to consume (MPC) = 0.7

(b) Multiplier of this economy:

     = 3.33

(c) Decrease government purchases by $300 billion,

Initial change in consumption = Change in government purchases × MPC

                                                 = $300 × 0.7

                                                 = -$210 billion

(d) This decreases income yet again, causing a second change in consumption equal to:

= Initial change in consumption × MPC

= -$210 × 0.7

= -$147 billion

(e) The total change in demand resulting from the initial change in government spending is:

= Change in government purchases × Multiplier

= $300 × 3.33

= -$1 trillion