This decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to __.
The correct answer and explanation is:
Correct Answer: A decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to the marginal propensity to consume (MPC) multiplied by the change in income.
In simple terms, the initial change in consumption equals:
ΔC = MPC × ΔY
Where:
- ΔC is the change in consumption,
- MPC is the marginal propensity to consume,
- ΔY is the change in income resulting from the decrease in government spending.
Government spending is a component of aggregate demand. When the government reduces its spending, it lowers the overall demand in the economy. This leads to a decrease in national income or gross domestic product (GDP), as firms respond to lower demand by reducing production, which in turn leads to job losses or lower wages. As household income decreases, people also reduce their spending.
The marginal propensity to consume (MPC) is a measure of how much consumption changes with a change in income. For example, if the MPC is 0.8, then for every shilling lost in income, consumption will fall by 80 cents. The initial drop in consumption is a direct result of the first round of income reduction.
This concept is central to the Keynesian multiplier effect. It shows how an initial change in government spending causes a ripple effect throughout the economy. The first round of reduced income leads to a proportional decrease in consumption. Later rounds follow as that lower consumption becomes reduced income for others, leading to further consumption decreases. However, the initial change in consumption always stems from the MPC multiplied by the initial income change, before any further rounds of adjustment occur.
Understanding this helps in policy-making decisions, especially in estimating the impact of fiscal contraction or expansion on the overall economy.