Question

Consider two economies, A and B. Economy A has a marginal propensity to consume of 0.9, a net tax rate of 0.3 and a marginal propensity to import of 0.3. Economy B has a marginal propensity to consume of 0.9, a net tax rate of 0.1 and a marginal propensity to import of 0.3. Suppose there is an increase in autonomous investment of $5 billion in each of these economies. Which of the following statements is true?

Group of answer choices

There is a larger decrease in real GDP in Economy A as a result of the change in autonomous investment.

There is a larger increase in real GDP in Economy B as a result of the change in autonomous investment.

There is a larger increase in real GDP in Economy A as a result of the change in autonomous investment.

There is an equal effect on real GDP in Economies A and B as a result of the increase in autonomous investment.

There is a larger decrease in real GDP in Economy B as a result of the change in autonomous investment.

Answer 1

Increase in autonomous investment leads to increase in real GDP.

Economy A

Marginal propensity to consume, MPC = 0.9

MPS = 1 - MPC = 1 - 0.9 = 0.1

Net tax rate, t = 0.3

Marginal propensity to import, MPI = 0.3

Calculate Multiplier -

Multiplier = 1/[MPS + t + MPI]

Multiplier = 1/[0.1 + 0.3 + 0.3] = 1/0.7 = 1.43

The Multiplier in economy A is 1.43

Calculate the increase in real GDP -

Increase in real GDP = Increase in autonomous investment * Multiplier = $5 billion * 1.43 = $7.15 billion

Thus,

The real GDP in economy A will increase by $7.15 billion.

Economy B

Marginal propensity to consume, MPC = 0.9

MPS = 1 - MPC = 1 - 0.9 = 0.1

Net tax rate, t = 0.1

Marginal propensity to import, MPI = 0.3

Calculate Multiplier -

Multiplier = 1/[MPS + t + MPI]

Multiplier = 1/[0.1 + 0.1 + 0.3] = 1/0.5 = 2

The Multiplier in economy B is 2

Calculate the increase in real GDP -

Increase in real GDP = Increase in autonomous investment * Multiplier = $5 billion * 2 = $10 billion

Thus,

The real GDP in economy B will increase by $10 billion.

So,

There is a larger increase in real GDP in Economy B as a result of the change in autonomous investment.

Hence, the correct answer is the option (B).