If the marginal propensity to consume in the economy is 0.8 and the government increases its spending this year by €10 billion, what will be the additional increase in expenditure in the economy next year?
A) €10 billion
B) €8 billion
C) €2 billion
D) €0.8 billion

Question

Quizplus · Accepted Answer

The additional increase in expenditure in the economy next year will be determined by the multiplier effect. The multiplier is calculated as 1/(1-MPC), where MPC is the marginal propensity to consume. In this case, the multiplier is 1/(1-0.8) = 5. So, the additional increase in expenditure in the economy next year will be 5 times the initial government spending increase of €10 billion, which is €50 billion. However, we are asked for the additional increase in expenditure in the economy next year, which is the increase over and above what would have happened anyway due to the initial €10 billion government spending increase (known as the "autonomous" increase). The autonomous increase will be equal to MPC times the initial government spending increase, which is 0.8 x €10 billion = €8 billion. Therefore, the additional increase in expenditure in the economy next year (i.e. the increase over and above the €8 billion autonomous increase) will be €50 billion - €8 billion = €42 billion.

If the Marginal Propensity to Consume in the Economy Is