Suppose that an initial $10 billion increase in investment spending expands GDP by $10 billion in the first round of the multiplier process. Also assume that GDP and consumption both rise by $8 billion in the second round of the process. A) What is the MPC in this economy?

B) What is the size of the multiplier?

Answer: A. MPC = 0.8

B. Multiplier = 5

Explanation:

Given in the question above, we have:

Change in consumption = $8 billion

Change in income = $10 billion

(We know, GDP = C + I + G + (X-M)

Where;

C = consumption

I = investment

G = government expenditure

X-M = net exports

Therefore, change in Investment by $10B means GDP automatically increases by $10B. Similarly, change in Consumption by $8B means GDP automatically increases by $8B.

a) The formula used to find MPC:

MPC = Change in consumption / Change in income

MPC = 8/10 = 0.8

Therefore MPC = 0.8

b) Formula to find multiplier:

k = 1 / (1-MPC)

k = 1/1-0.8

k = 1/0.2

k = 5.