Question

Assume that the economy is in equilibrium. The \(M P C\) is \(0.6\). Suppose investment demand rises by \(£ 30\). (a) By how much does the equilibrium output increase? (b) How much of that increase is extra consumption demand? Draw the corresponding diagram using planned investment and planned saving assuming that the initial output is 100 .

Short answer

Equilibrium output increases by £75, and extra consumption demand increases by £45.

Step-by-step solution

Understand the Multiplier Effect

The multiplier effect refers to the change in equilibrium output resulting from an autonomous change in aggregated demand, such as investment. The formula to calculate the multiplier is \( \frac{1}{1 - MPC} \), where MPC stands for the marginal propensity to consume.

Calculate the Multiplier

Given the MPC is 0.6, calculate the multiplier using the formula. The calculation is: \( \frac{1}{1 - 0.6} = \frac{1}{0.4} = 2.5 \). This multiplier indicates that for each unit increase in investment, the total increase in output will be 2.5 times that amount.

Determine Change in Equilibrium Output

The revised investment demand is £30. To find the increase in equilibrium output, multiply the change in investment by the multiplier: \( 30 \times 2.5 = 75 \). Therefore, the equilibrium output increases by £75.

Calculate Extra Consumption Demand

The extra consumption demand can be calculated by multiplying the MPC by the increase in output. Therefore, the calculation is: \( MPC \times \text{Change in Total Output} = 0.6 \times 75 = 45 \). Thus, the extra consumption demand increases by £45.

Draw the Diagram

To represent the changes via a diagram, plot planned investment and planned saving against output. Initially, assume output is 100. As investment increases by £30 and output increases by £75, shift the planned investment line upward. The increase in planned saving will match the increased planned investment at the new equilibrium, confirming that the new equilibrium output is higher.

Key concepts

Marginal Propensity to Consume (MPC)

The marginal propensity to consume, abbreviated as MPC, is a fundamental concept when studying the multiplier effect in economics. It quantifies the proportion of additional income that a household is likely to spend on consumption expenditures instead of saving. Specifically, if someone receives an extra pound, how much of that do they spend as consumption?

MPC is expressed as a number between 0 and 1. An MPC of 0 means all additional income is saved, and none is consumed. Conversely, an MPC of 1 implies all additional income is consumed with none saved. In our example, an MPC of 0.6 signifies that 60% of any additional income will be used for consumption, while the remaining 40% is saved. This measure is crucial for determining the multiplier effect and the resultant changes in economic equilibrium.

Remember, the higher the MPC, the larger the multiplier effect—indicating a greater ripple effect on the economy from initial increases in spending.

Equilibrium Output

Equilibrium output refers to the level of national income where aggregate demand equals aggregate supply. At this point, the quantity of goods produced in an economy matches the quantity of goods demanded. In simple terms, everything that is produced within the economy is either sold or consumed.

When there is a change in autonomous demand, such as an increase in investment, the equilibrium output changes. We determined the increase in equilibrium output using the multiplier effect. Given an MPC of 0.6, the multiplier is calculated to be 2.5, which means any initial increase in investment will result in an output increase 2.5 times more than the investment.

For instance, with an additional £30 in investment, the equilibrium output rises by £75. This is because not only does the initial investment contribute to economic activity, but the subsequent rounds of spending multiply this impact, achieving the higher equilibrium output.

Investment Demand

Investment demand is the expenditure by businesses on capital goods, which includes machinery, buildings, infrastructure, and inventory. It is one of the primary components of aggregate demand besides consumption, government spending, and net exports. Investment demand can influence economic equilibrium significantly because it not only fuels immediate demand but also enhances productive capacity, leading to long-term economic growth.

In our scenario, when investment demand increases by an additional £30, it doesn't just lead to a £30 increase in output. Instead, due to the multiplier effect, the output eventually increases by £75. This underscores the vital role investment plays in an economy; it is a powerful driver of changes in overall economic activity.

Businesses consider various factors when deciding on the level of investment, including interest rates, expected future profitability, technology, and overall economic conditions. Hence, changes in investment demand can dramatically alter the economic landscape.

Consumption Demand

Consumption demand encompasses the total spending by households on goods and services. It is generally the largest component of aggregate demand within an economy. Consumption is directly influenced by the marginal propensity to consume. A rise in equilibrium output often increases consumption demand, as individuals tend to spend part of the additional income they receive.

In the exercise, when the equilibrium output increases by £75, the associated extra consumption demand is calculated by multiplying the MPC (0.6) with the total change in output. This results in an additional consumption demand of £45. This illustrates the linkage between extra income and increased spending in the economy.

Consumption patterns can vary widely between different economic contexts, influenced by income levels, consumer confidence, and access to credit. Understanding these patterns can provide insights into economic behavior and potential future trends in economic growth.