Question

If the marginal propensity to consume (MPC) is \(0.90,\) a \(\$ 100\) billion increase in planned investment expenditure, other things being equal, will cause an increase in equilibrium output of a. \(\$ 90\) billion. b. \(\$ 100\) billion. c. \(\$ 900\) billion. d. \(\$ 1,000\) billion.

Short answer

The increase in equilibrium output due to a $100 billion increase in planned investment expenditure, with a marginal propensity to consume of $0.90$, is: d. $1,000$ billion.

Step-by-step solution

Define the Multiplier

The multiplier is defined as the ratio of the change in equilibrium output to the change in investment spending. It can be calculated using the following formula: \(K = \frac{1}{1 - MPC}\) where K is the multiplier and MPC is the marginal propensity to consume.

Calculate the Multiplier

In this exercise, the MPC is given as \(0.90\). Insert this value into the multiplier formula: \(K = \frac{1}{1 - 0.90}\) \(K = \frac{1}{0.10}\) \(K = 10\) So, the multiplier in this case is 10.

Calculate the Increase in Equilibrium Output

Now we can use the multiplier to find the change in equilibrium output due to the increase in investment spending. Multiply the given increase in planned investment expenditure of $100 billion by the multiplier: \(\Delta Y = K \times \Delta I\) \(\Delta Y = 10 \times \$100\) billion \(\Delta Y = \$1,000\) billion So, the increase in equilibrium output is \(1,000\) billion.

Identify the Correct Answer

The correct answer among the given options is: d. \(\$ 1,000\) billion.

Key concepts

Multiplier Effect

The multiplier effect is a central concept in Keynesian economics which explains how an initial change in spending can lead to a larger change in overall economic output. When an individual or company spends money, this increases the income for another individual or company, who then also spend more, thereby multiplying the original expenditure throughout the economy.

For example, imagine a government decides to build a new bridge and spends money on resources and labor. The workers and suppliers receiving this money then have more to spend themselves. They might buy groceries, pay for services, or purchase new clothes, thus further stimulating the economy.

The formula to calculate the multiplier is given by \(K = \frac{1}{1 - MPC}\)where \(K\) is the multiplier, and MPC stands for the marginal propensity to consume. The MPC is the proportion of additional income that an individual is willing to spend on consumption instead of saving it. It varies between 0 and 1, and the closer it is to 1, the stronger the multiplier effect, as more of each dollar is spent and re-spent within the economy.

Equilibrium Output

Equilibrium output, also known as the equilibrium level of GDP, is a state where the total output of an economy precisely equals the total demand for goods and services. This balance ensures that there is no unintended buildup of inventories, meaning that all goods produced are being consumed or invested in.

The concept of equilibrium is crucial for understanding how an economy operates because it implies a situation where there are no widespread shortages or surpluses in markets. When an economy is at equilibrium, all resources are fully utilized, but not to an extent that would cause inflationary pressures.

At equilibrium, the amount that producers are prepared to supply is exactly matched by the amount that consumers and businesses are willing to buy. Changes in factors like investment expenditure, government spending, or external trade can shift this equilibrium, leading to either expansion (if output rises) or contraction (if output falls) of economic activity.

Investment Expenditure

Investment expenditure represents the amount of money spent on investments within an economy and is a component of the total aggregate demand. It includes spending on new machinery, buildings, and inventory by businesses, as well as expenditures by the government on infrastructure projects. It does not include financial investments like stocks and bonds.

When businesses anticipate that future profits will rise due to expanding markets or new technologies, investment expenditure is likely to increase. This expenditure is critical to an economy because it leads to more production capabilities and can enhance productivity and efficiency. Additionally, investment expenditure plays a key role in the multiplier effect. An initial increase in investments can significantly impact the overall economy - far more than the initial sum spent on the investment. This is because investment is not only a demand itself but also adds to the productive capacity of the economy, potentially leading to higher future incomes and further increased spending.