Macro Unit 3 The Multiplier

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Assume the marginal propensity to consume is .8. How will a decrease in taxes of $100 billion and a decrease in government spending of $100 billion affect aggregate demand (AD)?

• AD will decrease by $900 billion

• AD will decrease by $500 billion

• AD will decrease by $400 billion

• AD will decrease by $100 billion

• AD will not change

Answer explanation

The decrease in government spending will initially reduce income by the entire $100 billion because it is taking money out of the economy. The spending multiplier is =11−MPC=11−0.8=5 , so the decrease in spending will change aggregate demand by −$100 billion × 5 = −$500 billion. The tax multiplier is =−MPC1−MPC=−0.81−0.8=−4 , so the tax cut will only change aggregate demand by −$100 billion × −4 = $400 billion. Therefore, the net effect on aggregate demand (−$500 billion + $400 billion) is a decrease of $100 billion.

Based on the level of savings and disposable income data in the table, which of the following must be true?

• The marginal propensity to save is .2

• The marginal propensity to save is .9

• When disposable income is $12,000, consumption is $10,000

• The marginal propensity to consume is .1

• The marginal propensity to consume is .9

Answer explanation

The marginal propensity to consume plus the marginal propensity to save equals 1. The marginal propensity to save is the change in savings divided by the change in disposable income. The marginal propensity to save =($2,200−$2,000)($12,000−$10,000)=$200$2,000=0.1 . Therefore, the marginal propensity to consume is =1−0.1=0.9 .

Based on the data on savings and disposable income in the table, what are the income tax multiplier and the spending multiplier?

• The tax multiplier is -.1 and the spending multiplier is .9

• The tax multiplier is .2 and the spending multiplier is -.8

• The tax multiplier is -2 and the spending multiplier is 8

• The tax multiplier is -9 and the spending multiplier is 10

• The tax multiplier is 10 and the spending multiplier is -1

Answer explanation

The tax multiplier =−MPC(1−MPC)=−0.9(1−0.9)=−9 . The spending multiplier =1(1−MPC)=1(1−0.9)=10 .