Assignment 5.1: Homework - Marginal Propensity to Consume and the Multiplier

A study in Italy by Jappelli and Pistaferri (2014) showed the following the average marginal propensity to consume (MPC) is c₁ = .52.

They then looked at how different groups had different marginal propensities to consume. In particular:

For Group 1 of Italians, their MPC is c₁ = .3

For Group 2 of Italians, their MPC is c₁ = .65

Now, take the following hypothetical situation about the Italian economy:

M = X = 0

G = 500, T_p=500

C = 1000 + c₁(Y-T_p)

I = 200

Round to two decimal places in answers below:

1.First let's imagine all Italians have the average MPC of c₁ = .52

a.What is the equilibrium level income?

b.If the gov't increases spending by 200, what is the new equilibrium level of income?

c.What is the multiplier on government spending?

d.If government spending stays at 500, and instead they lower personal taxes by 200, why is the new equilibrium level of income?

e.What is the multiplier on the tax reduction?

f.Which multiplier is larger?

g.Why are they different?

2. Now, let's look at the effect of difference in MPC. a. Fill out the following table (your answer for all Italians should come from question 1) Effect of Difference in MPC Marginal propensity to consume Multiplier on government spending All Italians .52 Group 1 3 Group 2 65