Suppose that the marginal propensity to consume is 0.8. If disposable income increases by $0.5 trillion, by how much will consumption expenditure change?
The correct answer and explanation is :
Answer:
The change in consumption expenditure can be calculated using the Marginal Propensity to Consume (MPC) formula:
[
\Delta C = MPC \times \Delta Y_d
]
Where:
- (\Delta C) = Change in consumption expenditure
- (MPC = 0.8) (Given)
- (\Delta Y_d = 0.5) trillion (Increase in disposable income)
Substituting the values:
[
\Delta C = 0.8 \times 0.5
]
[
\Delta C = 0.4 \text{ trillion}
]
Thus, consumption expenditure will increase by $0.4 trillion.
Explanation:
The marginal propensity to consume (MPC) measures the proportion of additional income that a household spends on consumption rather than saving. It is a key concept in Keynesian economics and helps in understanding the relationship between income and consumption.
In this case, the MPC is 0.8, meaning that for every additional dollar of disposable income, 80 cents is spent on consumption while 20 cents is saved.
When disposable income increases by $0.5 trillion, households allocate 80% of this additional income to consumption. Using the MPC formula, we calculated that consumption expenditure increases by $0.4 trillion.
This concept is important because it helps in analyzing multiplier effects in the economy. If MPC is high, it leads to greater increases in aggregate demand, thereby stimulating economic growth. Conversely, if MPC is low, a significant portion of additional income is saved, leading to slower economic expansion.
In practical policy-making, governments use this concept to design fiscal policies such as tax cuts or stimulus payments. If policymakers aim to boost economic activity, they may target households with a high MPC, ensuring that more of the additional income gets spent rather than saved, thereby increasing overall demand and economic output.