Question

Consider a hypothetical closed economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25.
The marginal propensity to consume (MPC) for this economy is ___(0.25 / 0.75 / 1 / 1.33 / 4)___ , and the spending multiplier for this economy is ____(0.25 / 0.75 / 1 / 1.33 / 4)____ .

Suppose the government in this economy decides to decrease government purchases by $250 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to ____(-1,000billion / -500billion / -187.5billion / -93.8billion / -62.5billion)___ . This decreases income yet again, causing a second change in consumption equal to ___(-1000billion / -500billion / -93.8billion / -140.6billion / -62.5billion)____ . The total change in demand resulting from the initial change in government spending is .

Answer 1

Answer and Explanation:

According to the scenario, computation of the given data are as follow:-

1) Marginal propensity to consume (MPC) for this economy is 0.75 as it denotes the spending of the household and saving of 0.25 and the spending multiplier for this economy is

= Spending Multiplier(M)

= 1 ÷ 1 - MPC

= 1 ÷ 1-0.75

= 1 ÷ 0.25

= 4

2). Decrease in government purchases will lead to a decrease in income, generating an initial change in consumption

= -Amount of Government Decrease Purchases by × MPC

= -$250 billion × 0.75

= -$187.5 billion

3). Decrease income again, causing a second change in consumption

= Amount Decrease in Government Purchases × MPC

= -$187.5 billion × 0.75

= $140.6 billion

4).Total change in demand resulting from the initial change in government spending

=  Amount of Government Decrease Purchases by × Spending Multiplier(M)  

= $250 × 4

= $1,000 billion

= $1 trillion

As we can see that the income falls by $1000 billion in the end, so AD shifts to the left by the size of $1 trillion

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