Question

 6. The government-purchases multiplier and the MPC

 Consider two closed economies that are identical except for their marginal propensity to consume (MPC). Each economy is currently in equilibrium with income and planned expenditure equal to $100 billion, as shown by the black Xs on the following two graphs. Neither economy has taxes that change with income. The grey lines show the 45-degree line on each graph.

 The first economy's MPC is 0.5. Therefore, its initial planned-expenditure function has a slope of 0.5 and passes through the point (100, 100).

 The second economy's MPC is 0.75. Therefore, its initial planned-expenditure function has a slope of 0.75 and passes through the point (100, 100).

 Now, suppose there is an increase of $20 billion in government purchases in each economy. Place a green line (triangle symbols) on each graph showing the new planned-expenditure function for each economy. Then place a red point (cross symbol) on each graph showing the new level of equilibrium Income. (Hint: You can see the slope and vertical axis intercept of a line on the graph by scrolling over the line with your cursor. You can also see the coordinates of the points on a line by scrolling over them with your cursor. You may want to do this to ensure that you've accurately plotted the new line.)

 In the first economy (with MPC = 0.5), the $20 billion increase in government purchases causes equilibrium income to increase by _______  .In the second economy (with MPC = 0.75), the $20 billion increase in government purchases causes _______  equilibrium income to increase by _______ .Therefore, a higher MPC is associated with a _______  multiplier.

 Now, confirm your graphical analysis algebraically using the formula for the government-purchases multiplier:

 Government-Purchases Multiplier= 1/ 1- MPC

 For the first economy with an MPC of 0.5, the effect of the $20 billion increase in government purchases becomes the following:

 

 Using the same method, the multiplier for the second economy is _______ 

Answer 1

First Economy

1. 0.5 (MPC)

2. 0.5

3. 2(Multiplier)

4. $40 billion

Second Economy

1. 0.75(MPC)

2. 0.25

3. 4 (Multiplier)

4. $80 billion