Question

What are the marginal propensity to consume and marginal propensity to save and the multiplier?

What is that money is neutral in the long run but not in the short run?

Answer 1

Marginal Propensity to consume In an economy aggregate demand consists of C+I+G+(X-M. Among these consumption is the major component. Consumption is a function of income C-f(y). The functional relationship between income and consumption is known as consumption function With cvery increase in income the consumption also incrcase but less than proportionately to the increase in income. The consumption function is determined by the marginal propensity to consume (MPC) Marginal propensity to consume shows how much increase in income is spend on consumption. In other words MPC shows the ratio between change in income AC and change in income AY The relation between an increment in consumption and an increment in income is that the consumption incrcase with every incrcase in incomc but less than proportionately to the increment in incomc. This is because as income incrcasc the propensity to save also increases. Thus a considerable part of income increase will be channeled in to saving MPC AC AY The MPC lies between 0 and 1. It is greater than 0 but less than 1. MPC >0<1 Suppose a person's salary is S1000 per month and his consumption is $800 per month Suppose the person get an increment salary by S400 and with the increase in income his consumption increase by $200 The his MPC 200 which is equal to 0.5 400

changes in income as a resu of initial change in investmen Investment multiplier is the ratio of change in income due to change in investment. The value of multiplier depends upon the value of marginal propensity to consume. The increase in investment by the government generate in income which is consumed and the increased consumption further increase the investment in private sector and income and investment and so on. If the MPC is high the value of multiplicr is also high. For example: the initial investment increases by $5 crore and income increase by $20 crores, then multiplier will be 20 S4 crore It says how much time the income increase as a result of the increase in investment Change in investment » Change in income > Change in consumption »Change in income The value of multiplierChange in income Change in initial investment The income is divided between consumption and saving. Thus the size of multiplier is determined by the size of MPC which further determined by the size of MPS If MPS is high MPC will be low and thereby the size of multiplier is also small and vice versa Neutrality of Money in shortrun and longrun The concept of neutrality of money was introduced by the Neo- classical economist Milton Friedman. In his opinion money can be compared to a veil. I