A government injects $200 billion in new spending into an economy where households save exactly 25 cents of every additional dollar of income. According to the Keynesian spending multiplier, what is the predicted total increase in output?
A$200 billion — government spending only creates output equal to its own amount
B$400 billion — the multiplier is 2 when MPS = 0.25
C$800 billion — the multiplier is 4 when MPS = 0.25
D$2,500 billion — the multiplier is 12.5, since 75% gets re-spent each round
MPS = 0.25 means MPC = 0.75. The fiscal multiplier = 1/MPS = 1/0.25 = 4. Each round of government spending becomes someone's income, 75% of which is re-spent, 75% of that is re-spent again, and so on. Total output = $200B × 4 = $800 billion. Option B ($400B) corresponds to a multiplier of 2, which would result from MPS = 0.5. Option A reflects the misconception that government spending only creates its own direct effect, ignoring the chain of secondary spending.
Question 2 Multiple Choice
A news report states that 'as incomes rose last year, households' marginal propensity to save increased.' A critic responds: 'But the fraction of total income that households saved actually fell.' Are both statements compatible?
ANo — if MPS increased, then the share of total income saved must have increased too
BYes — MPS describes behavior at the margin (fraction of each additional dollar saved), while APS describes total saving as a share of total income; they can move in different directions
CNo — MPS and APS are mathematically the same quantity expressed differently
DYes — but only if the entire income distribution shifted dramatically
MPS and APS measure different things. MPS = change in saving / change in income (a marginal measure of behavior at the next dollar). APS = total saving / total income (an average measure across all income). They can move in different directions: if new income accrues primarily to higher-income households who save more at the margin, MPS can rise even while APS falls due to dissaving or low saving rates at the bottom. The marginal vs. average distinction is fundamental throughout economics.
Question 3 True / False
In the simple Keynesian model, a higher marginal propensity to save makes fiscal stimulus more powerful, because saved money remains in the economy and funds investment.
TTrue
FFalse
Answer: False
In the simple Keynesian model, savings are a 'leakage' — each dollar saved exits the consumption cycle and does not immediately generate further rounds of spending. The fiscal multiplier = 1/MPS, so a higher MPS produces a smaller multiplier: MPS = 0.4 gives a multiplier of 2.5; MPS = 0.2 gives a multiplier of 5. Higher MPS means stimulus is less powerful, not more. (In fuller models, savings fund investment with its own multiplier effects — but within the basic Keynesian framework, higher MPS unambiguously shrinks the spending multiplier.)
Question 4 True / False
In the simple Keynesian model, every additional dollar of disposable income must either be consumed or saved — the two propensities always sum to exactly 1.
TTrue
FFalse
Answer: True
MPC + MPS = 1 by definition within the two-use framework. A dollar of additional income has only two destinations: consumption and saving. Whatever fraction is not consumed is saved, and vice versa. This is why MPS = 1 − MPC exactly. The identity holds because the framework defines saving as all non-consumption uses of income, making the two categories exhaustive and mutually exclusive.
Question 5 Short Answer
Explain why savings are called a 'leakage' in the Keynesian spending multiplier, and how this connects MPS to the power of fiscal policy.
Think about your answer, then reveal below.
Model answer: Savings are called a leakage because each round of spending generates income, only part of which (MPC) gets re-spent — the rest (MPS) exits the spending cycle. The multiplier = 1/MPS captures exactly how fast income leaks out: a high MPS means most of each additional dollar is saved rather than re-spent, so the chain of secondary spending is short and weak. A low MPS means most gets re-spent, producing many more rounds of secondary income and a large total output effect. Fiscal policy is most powerful in high-MPC (low-MPS) economies because each dollar of government spending travels further through the economy before leaking out.
The leakage metaphor makes the multiplier intuitive: imagine a bucket with a hole. Water poured in (government spending) flows through (consumption) but leaks out (saving) at each stage. A bigger hole (higher MPS) means less water remains circulating. The multiplier formula 1/MPS simply sums the infinite geometric series of re-spending rounds, each of which retains only MPC of the previous round.