Consider the closed (no exports or imports) Latverian economy in which the consumption function is C = 300 + 0.75DI (where DI = Y - T is Disposable Income) and investment (I) is always $900. Government purchases are fixed at $1,300, and net taxes are fixed at $1,200. The next four questions refer to this model.

What is the marginal propensity to consume in this problem?

0.66

Explanation:

Marginal propensity to consume is the proportion of disposable income that is spent on consumption

Marginal propensity to consume = change in consumption / change in income = C / Y

Gross domestic product (Y) is the sum of all final goods and services produced in an economy within a given period which is usually a year.

In a closed economy, GDP = Consumption + Investment spending + Government Spending

Y = 300 + 0.75 (Y - $1,200) + $900 + $1,300

Y = 300 + 0.75Y - $900 + $900 + $1,300

Collect like terms

Y - 0.75Y = $1600

0.25Y = $1600

Y = $6400

Substitute for Y in the consumption function : 300 + 0.75 (Y - $1,200)

300 + 0.75 ($6400 - $1,200)

300 + 0.75 ($5,200) = $4,200

C = $4200

Marginal propensity to consume = $4,200 / $6400 = 0.66