Sept 2010 multiple choice question on marginal propensity

[students]

Why is the answer C?

If the economy is at equilbrium level, then shouldn't S = I?

And if this is true, and we know that I = £500m, then S = £500m.

If marginal propensity to save is 0.1, then £500m/0.1 = £5000m, which means that Cd = £4500m (£500m saved, £4500 spent).

So Cd + autonomous expenditure = £4500 + £200 = £4700m.

What am I missing?

Thanks very much

 

[Charlie]

Yes, in equilibrium, S = I = 500.

The bit that you're missing is how autonomous consumption works.

Autonomous consumption is the part of consumption that does not depend on GDP, so, as an expression:

consumption = autonomous consumption + mpc x GDP

(In the textbook they usually ignore autonomous consumption and just have C as a linear function of GDP.)

Since mps = 0.1, we must have mpc = 0.9.

So:

C = 200 + 0.9 x GDP.

In equilibrium, GDP = E = C + I
= 200 + 0.9 x GDP + 500

ie: 0.1 x GDP = 700,

so equilibrium GDP = 7000.

Substituting this into our consumption formula gives:

C = 200 + 0.9 x 7000 = 6500, ie option C.

 

[students]

That's great. Thanks. I used your logic to answer another question and I got the correct answer so kudos to the teacher

I am ok for some of CT7, but not ok for others. Mostly because I have neglected the subject in favour of CT6. But alas, I have no one to blame but myself