CHAPTER TWENTY-SEVEN BASIC MACROECONOMIC RELATIONSHIPS

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1 CHAPTER TWENTY-SEVEN BASIC MACROECONOMIC RELATIONSHIPS CHAPTER OVERVIEW Previous chapters identified macroeconomic issues of growth, business cycles, recession, and inflation. In this chapter, the authors begin to develop tools to explain these events. The central purpose of this chapter is to introduce three basic macroeconomic relationships that will help to organize macroeconomic theories and controversies: the relationship between income consumed and income saved, the relationship between the interest rate and investment, and the relationship between changes in spending and changes in output. The spending multiplier is a key concept in understanding the effectiveness of fiscal policy in the chapters to come. PACING GUIDE The aggregate expenditure model is no longer part of the AP Macroeconomics Exam. So it is recommended that AP Macroeconomics teachers use this chapter to teach the concept of the multiplier and entirely omit Chapter 28. Spend three or four days on this chapter, and practice problems with the spending multiplier and the tax multiplier, which are the most likely to appear in a few multiple-choice questions on the AP Macroeconomics Exam. Material from this chapter is not part of the AP Microeconomics Exam. INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: 1. Understand that there are two things a person can do with income: spend it or save it. 2. Construct and explain the consumption and saving schedules. 3. Calculate and differentiate between the average and marginal propensities to consume and save. 4. Describe the relationship between the interest rate, expected rate of return, and investment. 5. Identify the determinants of investment and construct an investment demand curve. 6. Identify the factors that may cause a shift in the investment demand curve. 7. Describe the reasons for the instability in investment spending. 8. Explain the multiplier effect. 9. Calculate the multiplier and changes in real GDP, given information about changes in spending and the marginal propensities. 10. Explain why the actual multiplier may differ from the theoretical examples. 11. Define and identify terms and concepts listed at the end of the chapter. COMMENTS AND TEACHING SUGGESTIONS 1. Because the aggregate expenditure model is not tested on the AP exam, don t focus on graphs such as Figures 27.1, 27.2, 27.3, and Focus instead on the consumption function and numerical relationships among the propensities to consume and save, as well as calculation of the multiplier, to show the effects of changes in spending and investment. This chapter has been designed to seamlessly mesh directly into Chapter 29 without use of the aggregate expenditure model. 402

2 2. Have students practice calculating multiplier effects. It can help to give them detective work If we know that real GDP changed by $100 billion and spending changed by $25 billion, what can we conclude about the multiplier and MPC? 3. The multiplier concept can be demonstrated effectively by a role-playing exercise. The first row of students consists of construction workers who benefit from a $1 million increase in investment spending. If their MPC is.9, then they will spend $900,000 of their income at stores owned by a second row of students, who will in turn spend $810,000 (.9 x $900,000). At the end of the exercise, each row adds up its new income, and it will be well in excess of the initial $1 million. In fact, if played out to its conclusion, the final change in GDP should approximate $10 million, given that the MPS is.1 in this example. Adding up these increases illustrates the idea that the original $1 million increase in spending has resulted in many times that amount in terms of the students increased incomes. 4. Note that the multiplier effect can work in reverse, as well. The closing of a military base or a factory shutting down has a multiplied negative impact on the local community, reducing retail sales and placing a hardship on other businesses. Ask students to offer examples of the multiplier effect that they have witnessed. 5. Data to update Figure 27.1 may be found online at the Bureau of Economic Analysis. 6. Investment expenditures are the most volatile segment of aggregate expenditures and aggregate demand. Because the AP exam does not include the aggregate expenditures model, it is important to stress changes in investment demand in examples of changes in spending and investment in this chapter, in preparation to teach the AD/AS model. 7. Ask students to research a particular industry to find out what factors are most likely to influence investment decisions for that industry, or have students interview a local business manager or owner about their decision to add capital equipment. Make a list of the factors that they consider when making their decisions. Are they similar to the reasons given in the text? How were they different? STUDENT STUMBLING BLOCKS 1. Students sometimes get so caught up in the theory that they forget the basic relationships. To help them remember even simple things like MPC + MPS = 1, remind them that they can only do two things with their disposable income: spend it or save it. Invariably someone will ask, What about paying off credit cards (or other forms of debt)? Isn t that spending? Explain that repayment of debt is merely saving after the fact. If someone suggests that they can also pay taxes, you can remind them that disposable income is after-tax income. 2. The discussion of the income and consumption relationship is a good opportunity to remind students about the fallacy of composition. Unfortunately, it is also a potential stumbling block. When discussing marginal propensities, for example, it is on the one hand helpful to individualize the experience If you received an extra dollar, how much of it would you spend? On the other hand, how students answer such questions may cloud their ability to reason through what to expect in the aggregate. It is important to remind students that they are examining aggregate behavior and that they can t necessarily generalize from their individual experiences. LECTURE NOTES I. Learning Objectives In this chapter students will learn: A. How changes in income affect consumption (and saving). B. About factors other than income that can affect consumption. C. How changes in real interest rates affect investment. 403

3 II. D. About factors other than the real interest rate that can affect investment. E. How changes in investment increase or decrease real GDP by a multiple amount. The Income-Consumption and Income-Saving Relationships A. Disposable income is the most important determinant of consumer spending. B. Saving is the part of disposable income not consumed. C. Figure 27.1 represents graphically the recent historical relationship between disposable income (DI), consumption (C), and saving (S) in the United States. 1. A 45-degree line represents all points where consumer spending is equal to disposable income; other points represent actual C and DI relationships for each year from The difference between the 45-degree line and consumption represents the amount of income that is saved. D. Conclusions 1. Households consume a large portion of their disposable income. 2. Both consumption and saving are directly related to the level of income. E. The Consumption Schedule 1. A hypothetical consumption schedule (Table 27.1 and Key Graph 27.2a) shows that households spend a larger proportion of a small income than of a large income; households with higher incomes save more than households with lower incomes. 2. A hypothetical saving schedule (Table 27.1 and Key Graph 27.2b) shows that dissaving occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth. F. Average and Marginal Propensities 1. Average Propensity to Consume (APC) a. % of income consumed b. APC = consumption / income 2. Average Propensity to Save (APS) a. % of income saved b. APS = saving / income 3. APC + APS = 1 (% consumed + % saved = 100% of income) 4. Global Perspective 27.1 shows the APCs for several nations in Note the high APCs for Australia, the United States, and Canada. 5. Marginal Propensity to Consume (MPC) a. % of a change in income that is consumed b. MPC = change in consumption / change in income 6. Marginal Propensity to Save (MPS) a. % of a change in income that is saved b. MPS = change in saving / change in income 404

4 7. MPC + MPS = 1 (% of change consumed + % of change saved = 100% of change in income) G. Nonincome Determinants of Consumption and Saving 1. The amount of disposable income is the primary determinant of the amounts households will spend and save, but other factors may cause households to consume more or less. a. Wealth An increase in wealth increases consumption and reduces saving. In recent years, major fluctuations in stock market values have increased the importance of this wealth effect. A reverse wealth effect occurred in 2008, when stock prices fell dramatically. b. Borrowing Increased borrowing increases consumption and reduces saving. But eventually loans must be repaid, so the cost of current consumption is forgone future consumption. c. Expectations Changes in expected future prices or income can affect current spending and saving. Households that expect inflation will increase current spending before prices rise; households that expect a recession will reduce current spending to save for expected bad times. d. Real interest rates Lower interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Because most household spending is not interest sensitive, interest rate changes only have modest effects on spending. 2. Consider This The Great Recession and the Paradox of Thrift a. Concerned about reduced wealth, high debt, and potential job losses, households increased their saving and reduced their income in b. Paradox of thrift a recession can be made worse when households become thriftier and save in response to the economic downturn. Saving benefits the economy in the long run because it promotes investment and economic growth. But it hurts the economy in the short run, because when firms are pessimistic about future sales, they are less likely to engage in investment. c. When each household attempts to save more during a recession, the reduced demand for products lowers total income, which makes it more difficult for households to save. H. Other Important Considerations 1. Macroeconomic models focus more on real domestic output (real GDP) than on disposable income (Figure 27.4). 2. Movement from one point to another on a given schedule is a change in the amount consumed; a shift in the schedule is a change in consumption schedule, and is caused by nonincome determinants of consumption. 3. Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change. 4. Taxes shift both spending and saving in the same direction. Lower taxes increase both spending and saving, because households will spend part of a tax cut and save the rest. Increases in taxes reduce both savings and spending. 5. Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. 405

5 III. The Interest Rate Investment Relationship A. Investment consists of spending on new plants, capital equipment, machinery, inventories, and construction. 1. The investment decision is based on marginal benefit and marginal cost. 2. The expected rate of return is the marginal benefit. 3. The interest rate the cost of borrowing funds is the marginal cost. B. Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to the cost of the investment to get expected rate of return. 1. If a firm expects to make $100 profit on a $1000 investment, it has a 10% expected rate of return. Thus, the business would not want to pay more than a 10% interest rate on investment. 2. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk. C. The real interest rate, i nominal rate corrected for expected inflation determines the cost of investment. 1. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone. 2. If the real interest rate exceeds the expected rate of return, the investment should not be made. D. The investment demand curve shows an inverse relationship between the interest rate and amount of investment (Figure 27.5). 1. As long as the expected return exceeds the interest rate, the investment is expected to be profitable. Fewer projects are expected to provide a high return, so less will be invested if interest rates are high. 2. Investment projects should be undertaken up to the point where r = i; the investment demand curve shows the amount of investment that will occur at each real interest rate. E. Shifts in investment demand occur when any determinant apart from the interest rate changes (Figure 27.6). Greater expected returns create more investment demand and shift the curve to the right; lower expected returns cause a leftward shift. 1. Higher acquisition, maintenance, and operating costs of capital goods lower the expected return. 2. Increased business taxes lower the expected return. 3. Improvements in technology lower costs, which would increase expected returns. 4. The stock of capital goods on hand will affect new investment. If firms have abundant idle capital on hand because of weak demand or recent investment, new investment would be less profitable. 5. Increases in planned inventories, because the firm is expecting an increase in product sales, would increase investment. 6. If firms have positive expectations about future economic and political conditions, the expected rate of return increases and firms would increase investment. 406

6 IV. F. Investment is the most volatile component of total spending. Most of the fluctuations in output and employment that happen over the course of the business cycle can be attributed to demand shocks from unexpected changes in investment (Figure 27.7). 1. Business expectations can change quickly. 2. Capital goods are durable, so spending can be postponed. 3. Innovation occurs irregularly. 4. Profits vary considerably. G. Consider This The Great Recession and the Investment Riddle 1. During the Great Recession of , real interest rates declined to virtually zero, but investment still substantially declined during this period. 2. The investment demand curve had shifted to the left, reflecting firms expectations that they would earn no (or negative) returns on investment; hence, they stopped investing. The Multiplier Effect A. Multiplier effect a change in a component of total spending leads to a larger change in real GDP. 1. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read: Change in real GDP = initial change in spending x multiplier. 2. Three points to remember about the multiplier: a. The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier effect. b. The initial change in investment spending results from a change in the real interest rate and/or a shift of the investment demand curve. c. The multiplier works in both directions (increasing or decreasing). B. Rationale (Figure 27.8) 1. The economy has continuous flows of expenditures and income a ripple effect in which money spent by Person A becomes income for Person B, and Person B s spending becomes income for Person C. 2. Any change in income will change both consumption and saving in the same direction as the initial change in income, by a fraction of that change. a. Marginal propensity to consume (MPC) the fraction of the change in income that is spent. b. Marginal propensity to save (MPS) the fraction of the change in income that is saved. c. Multiplier = 1 / MPS or 1 / (1-MPC) C. The Multiplier and Marginal Propensities 1. The size of the MPC and the multiplier are directly related; the larger the proportion of income spent, the larger the multiplier effect (Figure 27.9). 2. The size of the MPS and the multiplier are inversely related; the larger the proportion of income saved, the smaller the multiplier effect. 407

7 3. The significance of the multiplier is that a small change in investment or consumption can trigger a much larger change in the equilibrium level of GDP. 4. Because of complications in the calculation of the multiplier (imports, taxes, inflation), the actual multiplier is somewhat different from the simple formula. Economists disagree about the size of the actual multiplier in the United States, with estimates ranging from 2.5 to zero. V. LAST WORD: Squaring the Economic Circle A. A decrease in consumption by one person sends ripple effects through the economy. B. Initial decreases in demand reduce output and employment in other industries, reducing output even further into a recessionary spiral. ANSWERS TO END-OF-CHAPTER QUESTIONS 27-1 What are the variables (the items measured on the axes) in a graph of the (a) consumption schedule and (b) saving schedule? Are the variables inversely (negatively) related or are they directly (positively) related? What is the fundamental reason that the levels of consumption and saving in the United States are each higher today than they were a decade ago? The consumption schedule measures consumption as a fraction of disposable income. The saving schedule measures saving as a fraction of disposable income. Consumption and saving are directly (positively) related to income. Consumption and saving are greater today primarily because income is greater Precisely how do the MPC and the APC differ? How does the MPC differ from the MPS? Why must the sum of the MPC and the MPS equal 1? MPC is the percentage of a change in income that is spent. APC is the percentage of total income that is spent. When income changes, households can only spend it or save it. MPC is the fraction of the change in income spent; therefore, the fraction not spent must be saved, and this is the MPS. The percentages of income spent and saved must add up to 100% of income; therefore MPC + MPS = In what direction will each of the following occurrences shift affect the consumption and saving schedules, other things equal? a. A large increase in real estate values, including private homes. b. A sharp, sustained increase in stock prices. c. A 5-year increase in the minimum age for collecting Social Security benefits. d. An economy-wide expectation that a recession is over and that a robust expansion will occur. e. A substantial increase in household borrowing to finance auto purchases. (a) Households have more wealth, so consumption increases and saving decreases. (b) Households have more wealth, so consumption increases and saving decreases. (c) The postponement of benefits may cause households to increase saving and reduce current consumption. (d) Favorable expectations about the economy lead households to increase consumption and reduce saving. (e) Increased borrowing allows households to increase current consumption and reduce saving. However, when the loans must be repaid in the future, at that time consumption will be reduced. 408

8 27-4 Why does a downshift of the consumption schedule typically involve an equal upshift of the saving schedule? What is the exception to this relationship? If, by definition, all that one can do with income is consume or save, then if one consumes less of any given income, one will necessarily save more. And if one consumes more, one saves less. This being so, when a consumption schedule shifts downward (meaning consuming less out of any given income), the saving schedule shifts upward (meaning saving more out of the same given income). The exception is a change in personal taxes. When these change, disposable income changes. Therefore, consumption and saving both change in the same direction, which is opposite to the change in taxes. If MPC, say, is 0.9, then MPS is 0.1. Now, if taxes increase by $100, consumption will decrease by $90 and saving will decrease by $ Why will a reduction in the real interest rate increase investment spending, other things equal? The basic determinants of investment are the expected rate of return (net profit) that businesses hope to realize from investment spending and the real rate of interest. When the real interest rate falls, investment increases because the expected rate of return is higher than the interest rate, so the firm expects a higher profit and is motivated to invest In what direction will each of the following occurrences shift the investment demand curve, other things equal? a. An increase in unused production capacity occurs. b. Business taxes decline. c. The costs of acquiring equipment fall. d. Widespread pessimism arises about future business conditions and sales revenues. e. A major new technological breakthrough creates prospects for a wide range of profitable new products. (a) Investment decreases because the firm already has unused capital, probably due to lower product demand. (b) Investment increases because the firm has more disposable income to invest. (c) Investment increases because the cost to buy equipment is lower, so expected net returns are higher. (d) Investment decreases because the firm does not expect a high rate of return on investment. (e) Investment increases because the firm expects a higher rate of return on the investment How is it possible for investment spending to increase even in a period in which the real interest rate rises? As long as expected rates of return rise faster than real interest rates, investment spending may increase. This is most likely to occur during periods of economic expansion Why is investment spending unstable? Investment is unstable because, unlike most consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. Another reason for the instability of investment is that new business ideas and the innovations that spring from them do not come at a constant rate. Profits and the expectations of profits also vary. Since profits (in the absence of borrowing) are essential for investment, changes in profit levels change levels of investment. 409

9 27-9 Is the relationship between changes in spending and changes in real GDP in the multiplier effect a direct (positive) relationship or is it an inverse (negative) relationship? How does the size of the multiplier relate to the size of the MPC? The MPS? What is the logic of the multiplier-mpc relationship? The relationship between changes in spending and changes in real GDP is a positive relationship. The larger the percentage of income spent, the larger the change in the multiplier effect. The multiplier is 1 / MPS or 1 / (1 MPC). So the larger the saving, the smaller the multiplier. The logic of the relationship is that as more is consumed, more income flows to the next buyer, and the next, and the next, increasing the multiple of money spent in the economy Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter s example? The actual multiplier (estimated to be between 0 and 2.5) is smaller because it includes other leakages from the spending and income cycle besides just saving. Imports and taxes reduce the flow of money back into spending on domestically produced output, reducing the multiplier effect (LAST WORD) What is the central economic idea humorously illustrated in Art Buchwald s piece, Squaring the Economic Circle? How does the central idea relate to economic recessions, on the one hand, and vigorous economic expansions, on the other? The central idea illustrated is the multiplier effect that exists in a market economy. One independently determined change in spending has an effect on another s income, which then sets in motion a chain of events whereby spending changes directly with the income changes. A decline in spending begins a chain of declines, or, in other words, the initial decrease in spending is multiplied in terms of the final effect of this single decision. This occurs because of the observation that any change in income causes a change in spending that is directly proportional to it. The multiplier effect helps us understand why there is a business cycle as opposed to a stable level of output growth from year to year. In the Buchwald piece, a downturn for one person became a downturn for everyone in that fictional economy. Likewise, if the story had begun with a burst of optimism and an increase in spending, it might have rippled through to expand everyone s fortunes. The multiplier intensifies the effect of a spending change, whether it is an increase or decrease. 410

10 ANSWERS TO END-OF-CHAPTER PROBLEMS 27-1 (Key Question) Refer to the table below. Level of Output and Income (GDP = DI) Consumption Saving APC APS MPC MPS $240 $244 $ $ $ $ $308 $324 $340 $356 $ a. Fill in the missing numbers in the table. b. What is the break-even level of income in the table? What is the term economists use for the saving situation shown at the $240 level of income? c. For each of the following items, indicate whether the value in the table is either constant or variable as income changes: the MPS, the APC, the MPC, the APS. (b) Break-even income = $260. Households dissave at lower incomes. (c) MPS is constant; APC is variable; MPC is constant; APS is variable Suppose that disposable income, consumption, and saving in some country are $200 billion, $150 billion, and $50 billion, respectively. Next, assume that disposable income increases by $20 billion, consumption rises by $18 billion, and saving goes up by $2 billion. What is the economy s MPC? Its MPS? What was the APC before the increase in disposable income? After the increase? MPC is.9 (= $18 billion / $20 billion). MPS is.1 (= $2 billion / $20 billion). APC was.75 before the increase in disposable income (= $150 billion / $200 billion) and.76 after the increase in disposable income (= $168 billion / $220 billion) (ADVANCED ANALYSIS) Suppose that the linear equation for consumption in a hypothetical economy is C = Y. Also suppose that income (Y) is $400. Determine (a) the marginal propensity to consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the average propensity to consume, (e) the level of saving, and (f) the average propensity to save. (a) MPC =.8 (b) MPS =.2 (= 1.8) (c) Consumption = $360 (= $40 + [.8 x $400]) (d) APC =.9 (= $360 / $400) 411

11 (e) Saving = $40 (= $400 $360) (f) APS =.1 (= 1.9) 27-4 (ADVANCED ANALYSIS) Linear equations for the consumption and saving schedules take the general form C = a + by and S = - a + (1 b)y, where C, S, and Y are consumption, saving, and national income, respectively. The constant a represents the vertical intercept, and b represents the slope of the consumption schedule. a. Use the following data to substitute specific numerical values for a and b in the consumption and saving equations. National Income (Y) $ Consumption (C) $ b. What is the economic meaning of b? Of (1 b)? c. Suppose that the amount of saving that occurs at each level of national income falls by $20 but that the values of b and (1 b) remain unchanged. Restate the saving and consumption equations inserting the new numerical values, and cite a factor that might have caused the change. (a) C = $ Y and S = $ Y (b) Because b is the slope of the consumption function, it is the value of the MPC. In this case, the slope is 6/10, which means for every $10 increase in income, consumption will increase by $6. (1! b) would be 1!.6 =.4, which is the MPS. (c) C = $ Y and S = $ Y A factor that might have caused the decrease in saving the increased consumption is the belief that inflation will accelerate. Consumers wish to stock up before prices increase. Other factors might include a sudden increase in wealth or decrease in indebtedness, or a decrease in personal taxes Use your completed table for problem 1 to solve this problem. Suppose the wealth effect is such that $10 changes in wealth produce $1 changes in consumption at each level of income. If real estate prices tumble such that wealth declines by $80, what will be the new level of consumption and saving at the $340 billion level of disposable income? The new level of saving? The new level consumption will be $316 (= $324 $8). The new level of saving will be $24 (= $16 + $8) (Key Question) Suppose a handbill publisher can buy a new duplicating machine for $500 and the duplicator has a 1-year life. The machine is expected to contribute $550 to the year s net revenue. What is the expected rate of return? If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine? Will it invest in the machine if the real interest rate is 9 percent? If it is 11 percent? The expected rate of return is 10 percent (= $50 expected profit / $500 cost of machine). The $50 expected profit comes from the net revenue of $550 minus the $500 cost of the machine. 412

12 If the real interest rate is 8 percent, the publisher will invest in the machine as the expected profit (marginal benefit) from the investment exceeds the cost of borrowing the funds (marginal cost). The firm will also invest if the real interest rate is 9 percent. But if the real interest rate is 11 percent, the marginal cost is greater than the marginal benefit, so the firm will not invest in the machine (Key Question) Assume there are no investment projects in the economy that yield an expected rate of return of 25 percent or more. But suppose there are $10 billion of investment projects yielding expected returns of between 20 and 25 percent; another $10 billion yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present them graphically, putting the expected rate of return (and the real interest rate) on the vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent? Aggregate investment is (a) $20 billion; (b) $30 billion; (c) $40 billion Refer to the table in Figure 27.5 and suppose that the real interest rate is 6 percent. Next, assume that some factor changes such that the expected rate of return declines by 2 percentage points at each prospective level of investment. Assuming no change in the real interest rate, by how much and in what direction will investment change? Which of the following might cause this change: (a) a decision to increase inventories; (b) an increase in excess production capacity? Investment will decrease by $5 billion because the expected rate of return has decreased. An increase in excess production capacity would cause this change. If the firm made the decision to increase inventories, it would instead increase its expected return on investment (Key Question) What will the multiplier be when the MPS is 0,.4,.6, and 1? What will it be when the MPC is 1,.90,.67,.50, and 0? How much of a change in GDP will result if firms increase their level of investment by $8 billion and the MPC is? If the MPC is.67? The multiplier for the MPS values: undefined, 2.5, 1.67, 1 The multiplier for the MPC values: undefined, 10, 3.03, 2, 1 If MPC is, change in GDP is $40 billion (= 5 x $8 billion) If MPC is.67, change in GDP is $24.24 billion (= 3.03 x $8 billion) Suppose that an initial $10 billion increase in investment spending expands GDP by $10 billion in the first round of the multiplier process. If GDP and consumption both rise by $6 billion in the second round of the process, what is the MPC in this economy? What is the size of the multiplier? If, instead, GDP and consumption both rose by $8 billion in the second round, what would have been the size of the multiplier? 413

13 If GDP and consumption both rise by $6 billion, the MPC is.833 and the multiplier is 6 (= 1 /.167). If GDP and consumption both rise by $8 billion, the MPC is.875 and the multiplier is 8 (= 1 /.125). 414