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True or False: If the marginal propensity to consume is 4/5, then a decrease in...

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rmgsara | Student, Undergraduate | (Level 1) eNoter

Posted March 26, 2012 at 2:38 AM via web

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True or False: If the marginal propensity to consume is 4/5, then a decrease in government spending of $1 billion decreases aggregate by $5 billion.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted March 26, 2012 at 2:47 AM (Answer #1)

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This statement is true.  The way that you can verify that it is true is by using the common equation for the spending multiplier that applies to government spending.

The common equation for the spending multiplier is

Spending multiplier = 1/(1- marginal propensity to consume). 

Your MPC is .8.  That means the multiplier is equal to 1/(1-.8) which is 1/.2, which is 5.  So, your MPC is 5.

So you have a decrease of $1 billion in government spending.  You multiply -$1 billion (because it's a decrease in spending) by 5 and you get -$5 billion.

Therefore, the statement is true.

 

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