The circular flow of income (3)
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1.
The following diagram illustrates the consumption function for a hypothetical economy. The MPC is constant.
(a) Define the Average Propensity to Consume (APC) and the Marginal Propensity to Consume (MPC).
(b) Using the diagram, explain how the APC and MPC are derived from the consumption function.
(c) Suppose the autonomous consumption expenditure is £50 billion and the MPC is 0.8. Calculate the multiplier.
(a)
- Average Propensity to Consume (APC): This is the proportion of disposable income that is spent on consumption. It is calculated as total consumption divided by total income. APC = Consumption / Income. It represents the average level of spending across all income levels.
- Marginal Propensity to Consume (MPC): This is the change in consumption resulting from a change in income. It is calculated as the change in consumption divided by the change in income. MPC = Change in Consumption / Change in Income. It represents the responsiveness of consumption to a change in income.
(b)
The consumption function shows the relationship between consumption and income. The APC is the point on the consumption function where the total consumption expenditure is divided by the total income. This gives the average proportion of income spent on consumption. The MPC is the slope of the consumption function. It represents the change in consumption for every unit change in income. In the diagram, the slope is the MPC. For every £1 increase in income, consumption increases by the MPC amount.
(c)
The multiplier is calculated as 1 / (1 - MPC). In this case, MPC = 0.8.
Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5
Therefore, the multiplier is 5.
2.
Question 3
The following table shows the components of aggregate demand in an economy. The autonomous consumption expenditure is £100 billion, the MPC is 0.6, and investment is £20 billion. Calculate the maximum increase in national income in the UK if government spending increases by £15 billion. Show your working.
| Component | Amount (£bn) |
| Consumption (C) | £60 |
| Investment (I) | £20 |
| Net Exports (NX) | £10 |
| Government Spending (G) | £40 |
Calculation:
- Initial AD: C + I + NX + G = £60 + £20 + £10 + £40 = £130 billion
- Change in G: £15 billion
- Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.6) = 1 / 0.4 = 2.5
- Maximum increase in national income = Multiplier x Change in G = 2.5 x £15 billion = £37.5 billion
Explanation: The increase in government spending directly increases aggregate demand. The multiplier effect amplifies this initial change. The MPC of 0.6 indicates that 60% of each additional income is spent, leading to further rounds of expenditure and income generation. The table provides the initial components of aggregate demand, allowing for the calculation of the initial AD and the subsequent impact of the change in government spending.
3.
Explain how the size of the multiplier is affected by changes in the Marginal Propensity to Save (MPS). Illustrate your answer with a numerical example.
The Marginal Propensity to Save (MPS) is the proportion of an additional unit of income that households choose to save rather than spend. The MPS is inversely related to the MPC (MPS = 1 - MPC). Therefore, a higher MPS implies a lower MPC, and consequently, a smaller multiplier.
The relationship is as follows:
- Higher MPS: More of an additional income is saved, leading to less spending and a smaller multiplier.
- Lower MPS: Less of an additional income is saved, leading to more spending and a larger multiplier.
Numerical Example:
Consider an economy with an MPC of 0.8 and an MPS of 0.2 (MPS = 1 - MPC = 1 - 0.8 = 0.2). The multiplier is 1 / (1 - 0.2) = 1 / 0.8 = 1.25. Now, suppose the MPC increases to 0.9. The new MPS is 0.1. The new multiplier is 1 / (1 - 0.1) = 1 / 0.9 = 1.11. As the MPC increases, the multiplier decreases.