Question

An article published in an economics journal found the following: "For the poorest households, the marginal propensity to consume was close to \(70 \% .\) For the richest households, the MPC was only \(35 \%\)." Assume that the macroeconomy can be divided into three sections. Section A consists of the poorest households, Section \(\mathrm{B}\) consists of the richest households, and Section C consists of all other households. a. Compute the value of the multiplier for Section A. b. Compute the value of the multiplier for Section \(\mathrm{B}\). c. Assume that there was an increase in planned investment of \(\$ 4\) billion. Compute the change in equilibrium real GDP if the \(M P C\) for the economy was 70 percent (or 0.70\()\). Compute the change in equilibrium real GDP if the \(M P C\) for the economy was 35 percent (or 0.35\()\).

Short answer

a. The multiplier for Section A (poorest households) is \(1 / (1 - 0.7) = 3.33\) \n b. The multiplier for Section B (richest households) is \(1 / (1 - 0.35) = 1.54\) \n c. The increase in equilibrium real GDP for a MPC of 70% is \(3.33 * 4 = \$13.32\) billion. For a MPC of 35%, the increase in equilibrium real GDP is \(1.54 * 4 = \$6.16\) billion.

Step-by-step solution

Calculate the Multiplier for Section A and Section B

The multiplier is calculated using the formula \( 1 / (1 - MPC) \). Since the MPC for the poorest households is given as \(70\% = 0.7\) for Section A, and \(35\% = 0.35\) for Section B, we use these values in our formula to calculate the multipliers for Sections A and B respectively.

Compute the change in equilibrium GDP

Based on the given increase in planned investment of $4 billion, we can compute the changes in the equilibrium GDP for different MPC values. The change in GDP is calculated as \( Change\_in\_GDP = multiplier * change\_in\_investment\). We use the calculated multipliers from Step 1, and the change in investment of $4 billion, to calculate the new equilibrium GDP for the economy if the MPC was 70 percent (or 0.7), and if it was 35 percent (or 0.35).

Interpretation of Results

The computed results will show how changes in the MPC affect the multipliers and subsequently, the real GDP in an economy. A higher multiplier represents greater sensitivity to changes in investment, resulting in larger changes in GDP.

Key concepts

Multiplier Effect

The concept of the multiplier effect is central to understanding how changes in investment can lead to amplified changes in the total output of an economy. It hinges on the notion that an initial increase in spending (like investment) can cause further spending by those who receive the initial amount. This chain reaction of spending continues to drive economic activity, steadily growing the GDP.
The formula for the multiplier is given by \( \text{Multiplier} = \frac{1}{1 - \text{MPC}} \), where MPC stands for Marginal Propensity to Consume. The MPC represents the portion of additional income that a household is likely to spend, rather than save.
For example, if the MPC is 0.7, households spend 70% of their additional income. This leads to a larger multiplier because more of each dollar is circulated and re-spent in the economy. Therefore, a higher MPC, like 0.7, results in a higher multiplier, causing a larger effect on GDP for the same amount of initial spending.

• A smaller MPC results in a smaller multiplier—less of the additional income is re-spent, reducing the impact on the economy.
• Understanding the multiplier effect gives insight into how policy changes, such as increasing government spending or investment, can significantly influence overall economic activity.

Equilibrium GDP

Equilibrium GDP refers to the level of GDP in an economy where total production and total planned spending are equal. It represents a state where everything produced in an economy is purchased. At this point, the economy is stable, and there are no tendencies for GDP to rise or fall unexpectedly.
Changes in factors like investment can shift equilibrium GDP. For instance, if the Marginal Propensity to Consume is known, and there's an increase in investment, we can use the multiplier to determine the change in equilibrium GDP: \[ \Delta GDP = \text{Multiplier} \times \Delta \, \text{Investment} \].
Take an example where MPC is 0.7. The multiplier would be \( \frac{1}{1-0.7} = 3.33 \). If investment increases by $4 billion, the change in equilibrium GDP would be \( 3.33 \times 4 \text{ billion} = 13.32 \text{ billion} \).
This shows how shifts in spending lead to equilibrium changes, guiding how economies can be adjusted to reach full employment and optimal output.

Macroeconomic Analysis

Analyzing macroeconomic variables like the multiplier effect and equilibrium GDP helps economists understand and predict economic trends and outcomes. Macroeconomic analysis focuses on the big picture, including national income, inflation, unemployment, and how different sectors of the economy interact.
By examining changes in components like investment, economists develop models to describe how these factors affect overall economic performance.
A crucial aspect is understanding how income distribution affects consumption patterns across different households. For example, lower-income households with higher MPCs might react differently to economic changes compared to wealthier households with lower MPCs. This knowledge is vital for crafting policies aimed at economic stability or growth.

• Macroeconomic analysis allows policymakers to address issues like recession by adjusting variables such as government spending and tax rates to influence GDP and employment positively.
• Through this analysis, economists also discuss potential solutions to inequality and inefficiencies in the economy, fostering an environment for sustainable growth.