The multiplier effect

Consider a hypothetical economy where there are no taxes and no foreign trade, and households spend $0.90 of each additional dollar they earn and save the remaining $0.10. The marginal propensity to consume (MPC) for this economy is

; the marginal propensity to save (MPS) for this economy is

; and the multiplier for this economy is

.

Suppose investment spending in this economy increases by $100 billion. The increase in investment will lead to an increase in income, generating an increase in consumption that increases income yet again, and so on.

Fill in the following table to show the impact of the change in investment spending on the first two rounds of consumption spending and, eventually, on total output and income.

Hint: Be sure to enter a negative sign in front of the number if there is a decrease in consumption.

ChangeinInvestmentSpendingChangeinInvestmentSpending	==	$100billion$100billion
FirstChangeinConsumptionFirstChangeinConsumption	==	billion
SecondChangeinConsumptionSecondChangeinConsumption	==	billion
TotalChangeinOutputTotalChangeinOutput	==	billion

In reality, households will not simply split an increase in income between saving and consumption of domestic output. A fraction of the additional income will go toward the payment of taxes, and a fraction will go to purchases of foreign goods (imports). Accounting for the effects of taxes and imports will the multiplier effect you found earlier.

Now suppose that households in this economy allocate each additional dollar of income in the following way. Households continue to save $0.10 of each additional dollar income; however, they now pay $0.05 in taxes on each additional dollar of income, and they now spend $0.10 of each additional dollar on imported goods. The remaining fraction of each additional dollar goes toward consumption of domestically produced output.

In this case, the fraction of an additional dollar of income that is notspent on domestic output is equal to

. Taking the impact of taxes and imports into consideration, the multiplier for this economy is

.

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