3.6 Demand Management - Fiscal Policy

Question 1

What is the equation linking income, consumption and saving?

Answer 1

Change in income –> change in saving + change in consumption

Question 2

What is “marginal propensity to save (MPS)”?

Answer 2

The additional saving due to an additional unit of income

Question 3

What is the equation of “marginal propensity to save (MPS)”?

Answer 3

(Change in save / change in income)

Question 4

What is “marginal propensity to consume (MPC)”?

Answer 4

The additional consumption due to an additional unit of income

Question 5

What is the equation of “marginal propensity to consume (MPC)”?

Answer 5

(Change in consumption / change in income)

Question 6

If the additional income is $500, and they consume $100 whilst saving $400, what is the MPC and the MPS?

Answer 6

MPS = 400/500 = 0.8 
MPC = 100/500 = 0.2

Question 7

What does “k” stand for?

Answer 7

Keynesian multiplier

Question 8

What is the Keynesian multiplier directly proportional to?

Answer 8

K is directly proportional to MPC

Question 9

What is the Keynesian multiplier indirectly proportional to?

Answer 9

K is indirectly proportional to MPS

Question 10

The size of the multiplier in a CLOSED economy can be calculated in two ways:

Answer 10

1) 1/ MPS
2) 1/1-MPC

(THIS IS THE SAME, as 1-MPC = MPS)

Question 11

The size of the multiplier in an OPEN economy can be calculated using the equation:

Answer 11

1/MPS + MPM + MRT

MPM = Marginal propensity to import 
MRT = Marginal rate of tax

Question 12

What is “marginal rate of tax (MRT)”?

Answer 12

The proportion of additional income that is taxed

Question 13

What is “marginal propensity to import (MPM)”?

Answer 13

The proportion of additional income that is spent on imports

Question 14

Why is using the equation (1/MPS + MPM + MRT) more accurate than (1/1-MPC)?

Answer 14

Because (1/1-MPC) may overstate the size of the multiplier. Some of the consumption spending (MPC) is on imports, so we need to reduce this to the marginal propensity to consume domestic goods and services. To get the most accurate measure of the multiplier, we should also remove the proportion of additional income that is saved, taxed and spent on imports.

Question 15

How do we calculate the change in GDP using the Keynesian multiplier?

Answer 15

Change in GDP = the multiplier × the change in autonomous expenditure

Question 16

If a government increases spending by $100m, and the MPC is 0.2, what is the change in GDP?

Answer 16

( 1 / 1 - 0.2 ) x $100m = $125

Question 17

What happens during “crowding out”?

Answer 17

Interest rate in an economy rises as government tries to borrow from domestic financial sector.
Due to this, consumptions and Investment fall - and the multiplier may not work
–> Due to crowding out of consumption and investment

Question 18

The supply of quantity of loanable funds is ______ proportional

Answer 18

The supply of quantity of loanable funds is positively proportional (the higher the interest rate, the higher the demand)

Question 19

The demand of quantity of loanable funds is ______ proportional

Answer 19

The demand for quantity of loanable funds is negatively proportional (the higher the interest rate, the lower the demand)

Question 20

If K = 0, what is the effect?

Answer 20

If K = 0

–> there is no change in GDP

–> fully crowded out. Increase in government spending was cancelled out by decrease in consumption + investment

Question 21

If 0< K < 1, what is the effect?

Answer 21

Overall still a good effect on the economy. GDP increases slightly as the fall in C + I is high, but not higher than the increase in government spending.

eg. 0.3

–> ΔGDP = 0.3 x ΔG

–> ΔGDP increases less then the ΔGovernment spending

–> C + I falling > ΔG increasing

Question 22

If K = Negative value, what is the effect?

Answer 22

Bad effect on economy. GDP falls as the fall in C + I is greater than the increase in government spending.

eg. -2

–> ΔGDP = -2 x ΔG

–> ΔGDP falls as the fall in C+ I is greater than the increase in ΔGovernment spending

–> C + I falling >>> ΔG increasing

Question 23

If K > 1, what is the effect?

Answer 23

Good effect on the economy. GDP increases as the increase in C + I is even greater than the increase in government spending.

eg. 3

–> ΔGDP = 3 x ΔG

–> ΔGDP increases more then the ΔGovernment spending

–> C + I increasing > ΔG increasing