Question

Two National Income identities are shown below:

(i) Y = C + I + G

(ii) Y = C + I + G + X – M

(a) Pick out the National Income identity for an open economy.

(b) If marginal propensity to consume (C) = 0.5 and marginal propensity to import (M) = 0.3, prove that the open economy multiplier is smaller than that of the closed economy

Answer 1

(a) Y = C + I + G + X - M

(b) Closed economy multiplier = \(\frac{1}{1-MPC}\) here \(\frac{1}{1-0.5}\) = \(\frac{1}{0.5}\)

Open economy multiplier = 2

Open economy multiplier = \(\frac{1}{1-MPC \,+\,MP Import}\)

Open economy multiplier = 1.25

the multiplier in closed economy is 2 and open economy is 1.25.