Question

In 1978 , Government increased its investment spending by $ 5 billion. Given that the MPC (Marginal Propensity to Consume) is $0.75$, and assuming further that the economy is initially in equilibrium at $\mathrm{\$}470$ billion, a) Determine its effect on equilibrium NNP; b) Assuming that instead of an increase by $\mathrm{\$}5$ billion, there was a drop in investment by $\mathrm{\$}5$ billion, what will happen to equilibrium NNP? c) Give the significance of your results.

Short answer

In conclusion, a $5 billion increase in government investment spending raised the equilibrium NNP from $470 billion to $490 billion due to a multiplier effect and the given MPC of 0.75. Conversely, a $5 billion decrease in government investment spending reduced the equilibrium NNP to $450 billion. This demonstrates the significant impact of government investment decisions on the overall economy.

Step-by-step solution

Understand the concept of Marginal Propensity to Consume (MPC)

The Marginal Propensity to Consume (MPC) is a key concept in economics. It represents the fraction of an additional dollar of income that is spent on consumption. In this exercise, the MPC is given as $0.75$. This means that when income increases by $1,consumptionwillincreaseby$0.75.

Understand the relationship between government spending, investment, and equilibrium NNP

Equilibrium NNP is reached when aggregate demand equals aggregate supply. An increase (or decrease) in government investment spending will lead to a change in aggregate demand, thereby affecting the equilibrium NNP level. The multiplier effect can be utilized to determine the overall impact of a change in government spending on equilibrium NNP. The multiplier is given by: $Multiplier=\frac{1}{(1-MPC)}$ Using this formula, we can determine the overall effect of a change in government spending on equilibrium NNP.

Determine the effect of increased government investment spending on equilibrium NNP

First, let's calculate the multiplier effect using the MPC of $0.75$: $Multiplier=\frac{1}{(1-0.75)}=4$ Next, we multiply this value by the increase in government investment spending of $5$ billion: $ChangeinNNP=Multiplier\times ChangeinInvestmentSpending$ $ChangeinNNP=4\times \mathrm{\$}5billion=\mathrm{\$}20billion$ Finally, add this value to the initial equilibrium NNP of $\mathrm{\$}470$ billion: $NewEquilibriumNNP=InitialNNP+ChangeinNNP=\mathrm{\$}470billion+\mathrm{\$}20billion=\mathrm{\$}490billion$ So, the new equilibrium NNP after the increase in government investment spending is $\mathrm{\$}490$ billion.

Determine the effect of decreased government investment spending on equilibrium NNP

Now let's calculate the effect of a decrease in government investment spending of $5$ billion: $ChangeinNNP=4\times (-\mathrm{\$}5billion)=-\mathrm{\$}20billion$ We now calculate the new equilibrium NNP: $NewEquilibriumNNP=InitialNNP-ChangeinNNP=\mathrm{\$}470billion-\mathrm{\$}20billion=\mathrm{\$}450billion$ So, the new equilibrium NNP after the decrease in government investment spending is $\mathrm{\$}450$ billion.

Explain the significance of the results

The results of this exercise demonstrate how changes in government investment spending can have significant effects on the equilibrium NNP in an economy. In this case, a $5$ billion increase in government investment spending raised the NNP from $\mathrm{\$}470$ billion to $\mathrm{\$}490$ billion (a $20$ billion increase), while a $5$ billion decrease in investment spending lowered the NNP to $\mathrm{\$}450$ billion (a $20$ billion decrease). Thus, government investment decisions can have powerful multiplier effects on the overall economy.

Key concepts

Understanding Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume, simply put, is the portion of extra income that a household is likely to spend rather than save. Think of it as if for every dollar you receive, how many cents would you spend? In our scenario, with an MPC of 0.75, 75 cents out of each additional dollar are spent. This is a crucial number because it affects how spending ripples through the economy.

Knowing the MPC helps us predict changes in consumer spending as a result of changes in income. If a government policy, for example, increases a household's disposable income, MPC can estimate the increase in consumption that will follow. This becomes vital when evaluating policy impacts on economic activity, like our textbook problem where a change in government investment spending occurs.

The Role of Government Investment Spending

Government investment spending is a powerful economic tool that directly influences the level of aggregate demand. It’s a bit like adding fuel to the economy's engine. When the government spends more on infrastructure, research, or education, it injects additional funds into the economic system, which can potentially lead to increased production and employment.

Higher investment spending by the government can translate to more jobs, which means more income for households. Those households will then spend a percentage of this income, determined by the MPC, on goods and services. This chain of events can increase overall economic output, and in our original exercise, contributes to a higher equilibrium National Net Product (NNP). Conversely, when government investment spending decreases, it can have a contracting effect on the economy.

Exploring the Multiplier Effect

The multiplier effect is the economic magic that boosts the impact of government investment spending. In essence, it describes how an initial injection of spending leads to a greater than proportionate change in the overall economic activity. It's like a snowball rolling down a hill—it starts small but grows in size as it picks up more snow.

The size of the multiplier depends on the MPC and is calculated using the formula $Multiplier=\frac{1}{(1-MPC)}$. The higher the MPC, the larger the multiplier effect. In our exercise, with an MPC of 0.75, the multiplier is 4. This implies that for every dollar the government spends, the NNP increases by four dollars. That's significant! It demonstrates why the MPC and the multiplier effect are so crucial when the government is considering how to intervene in the economy to encourage growth.