Question

Consider two nations, Spendia and Savia. The MPC for Spendia is 0.8, and the MPC for Savia is 0.5. Assume that both nations experience an increase in gross investment (I) of $100 million at their existing GDP levels.
a. Considering the multiplier effect, what will be the overall increase in income (Y) for each nation?
b. Now assume that a third nation experiences an increase of $250 million in its income and its gross investment (I) increases by the same amount as Spendia and Savia, which is $100 million.

The expenditures multiplier of this third nation is ________ suggesting an MPC of _________.

Answer 1

Answer:

a. Overall increase in income (Y) for Spendia is $500 million, while overall increase in income (Y) for Savia is $200 million

b. The expenditures multiplier of this third nation is 2.50 suggesting an MPC of 0.6.

Explanation:

a. Considering the multiplier effect, what will be the overall increase in income (Y) for each nation?

For Spendia

MPC = Marginal propensity to consume = 0.8

MPS = Marginal propensity to save = 1 - 0.8 = 0.2

Multiplier = 1 / MPS = 1 / 0.2 = 5

Overall increase in income (Y) for Spendia = Increase in gross investment * Multiplier = $100 million * 5 = $500 million

For Savia

MPC = 0.5

MPS = 1 - 0.5 = 0.5

Multiplier = 1 / MPS = 1 / 0.5 = 2

Overall increase in income (Y) for Savia = Increase in gross investment * Multiplier = $100 million * 2 = $200 million

b. Now assume that a third nation experiences an increase of $250 million in its income and its gross investment (I) increases by the same amount as Spendia and Savia, which is $100 million.

Note that generally in macroeconomics, savings (S) is equal to gross investment (I). Consequently, it is assumed that an increase in gross investment (I) eqauls to an increase in savings (S).

Based on this, we have:

Increase in income (Y) = $250 million

Increase in gross investment (I) = Increase in savings (S) = $100 million

MPS = Increase in savings / Increase in income = $100 / $250 = 0.40

Multiplies = 1 / MPS = 1 / 0.4 = 2.5

MPC = 1 - MPS = 1 - 0.4 = 0.6

Therefore, the expenditures multiplier of this third nation is 2.50 suggesting an MPC of 0.6.