In this exercise, you will determine how a change in government spending affects the GDP. But first, you will have to recall what you learned about the marginal propensity to consume (MPC).
1. Write your own definition of MPC.
2. Estimate your household MPC.
3. You get a raise that amounts to a change in your take home pay of $300/month.
a. Using your MPC from #2 above, determine how much of this $300 you recirculate into the economy.
b. You decide to spend $50 of the $300/month on a personal trainer. Using the MPC from #2 above, how much money will your trainer recirculate into the economy.
4. You have been working for a few years after college, and you decide to begin saving more money so that you can buy a house. What will happen to your household MPC as you start to save more money?
(a worked out example)
1. In this example, we will calculate the expenditure multiplier for an MPC of .95.
Expenditure Multiplier = 1/(1-mpc)
a. Calculate the denominator
(subtract the MPC from 1)
1.00 - .95 = .05
b. Convert the denominator into a fraction
.05 = 5/100
c. Divide 1 by the fraction
1¸ 5/100 1 * 100/5 = 20
The expenditure muliplier for an MPC of .95 is 20.
2. Using the expenditure multiplier from #1 above and a change in spending of
1 million dollars, we will calculate how a change in spending affects the GDP.
change in GDP = (change in spending) * (expenditure multiplier)
= 1 million * 20
= 20 million
(student activity)
1. The U.S. government decides to increase spending on national defense by 1 million dollars.
a. Assuming an MPC of .9, calculate the change in GDP. Make sure to indicate if the GDP increased or decreased.
b. Is this the actual change in GDP or an estimate of the change?
c. What will happen to the expenditure multiplier and the GDP if people decide to save more and spend less? (Hint: consider an MPC of .8).
2. Some in Congress would rather cut defense spending. They propose a cut in defense spending of 50 million dollars.
a. Using an MPC of .85, calculate the change in GDP.
b. Should the GDP increase or decrease?
3. A very small country has a GDP of $20 million annually. This country would like to expand its economy. So, the government decides to increase its spending by $200,000. Assuming an MPC of .97, estimate the final GDP of this country.