Consider a hypothetical closed economy in which households spend $0.60 of each additional dollar they earn and save the remaining $0.40. The marginal propensity to consume (MPC) for this economy is0.6 , and the spending multiplier for this economy is . Suppose the government in this economy decides to increase government purchases by $400 billion. The increase in government purchases will lead to an increase in income, generating an initial change in consumption equal to . This increases income yet again, causing a second change in consumption equal to . The total change in demand resulting from the initial change in government spending is .

The total change in demand resulting from the initial change in government spending is $1,000 billion

Explanation:

Marginal propensity to consume (MPC) = As with every additional increase in income, consumption increases by 0.60.

MPC = change in Consumption / Change in Income =

= 0.60 / 1

MPC = 0.60.

Spending or Expenditure Multiplier = 1 ÷ (1 - MPC)

Spending Multiplier = 1 ÷ (1 - 0.6) = 1 ÷ 0.4 = 2.5.

The consumption will increase by MPC, with 1 dollar increased, consumption increased by 0.60

Therefore, with $400 billion increase, Consumption will increase by 0.60 × 400 billion = $240 billion.

This increases income, causing a change in consumption at second times equal $240 billion × 0.6 = $144 billion.

The total change in income by this increment in government spending equals as:

Change in Demand = Multiplier × change in G

Change in Demand= $400 billion × 2.5 = $1,000 billion.

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