Problem:

A hypothetical economy's consumption schedule is given in the table below.

Use the information to answer the following:

1. If disposable income were $7400, how much would be saved?
2. What is the "break-even" level of disposable income?
3. What is this economy's marginal propensity to consume?
4. What is the average propensity to consume when disposable income is $7000? When disposable income is $8000?

Answer:

1. Saving is the difference between disposable income and consumption. Since consumption is $7320 when DI is $7400, saving = $7400 – $7320 = $80.
2. The break-even level of disposable income occurs where all income is spent and saving is zero. In this example, the break-even is at $7000.
3. The marginal propensity to consume is the ratio of the change in consumption to the change in disposable income. In the table, each change in income is $200 and each change in consumption is $160, so the MPC is 160/200 = .8.
4. The average propensity to consume is the ratio of consumption to income. At $7000, the APC is 7000/7000 = 1, while at $8000 it is 7800/8000 = .975.

Problem:

1. Suppose a $100 increase in desired investment spending ultimately results in a $300 increase in real GDP. What is the size of the multiplier?
2. If the MPS is .4, what is the multiplier?
3. If the MPC is .75, what is the multiplier?
4. Suppose investment spending initially increases by $50 billion in an economy whose MPC is 2/3. By how much will this ultimately change real GDP?

Answer:

1. The multiplier is defined as the ratio of the change in real GDP to the initial change in spending that brought it about. In this case, the multiplier is $300/$100 = 3.
2. The multiplier is 1/MPS = 1/.4 = 2.5, in this example.
3. As the MPS and the MPC sum to one, the multiplier can also be computed as 1/(1 – MPC) = 1/(1 – .75) = 1/.25 = 4.
4. The multiplier in this example is 1/(1 – 2/3) = 3. The ultimate change in GDP is 3 x $50 = $150 billion.