In an open economy, the marginal propensity to consume is 0.8 and the marginal propensity to import is 0.2. Exports rise by 50 and, at the same time, the government cuts its purchases by 50. What happens to equilibrium income and to net exports?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Income does not change; net exports rise by 50
Exports and government purchases are both autonomous demand for domestic output, so they have the same multiplier, 1 ÷ (1 − c + m). Net exports change by the change in exports minus the change in imports, and imports change only if income changes.
Given:
c = 0.8, m = 0.2
ΔX = 50
ΔG = −50
\( \displaystyle \text{Multiplier} = \frac{1}{1 - 0.8 + 0.2} = 2.5 \)
\( \displaystyle \Delta Y = 2.5 \times (50 - 50) = 0 \)
\( \displaystyle \Delta M = m\,\Delta Y = 0 \)
\( \displaystyle \Delta NX = \Delta X - \Delta M = 50 - 0 = 50 \)
Income does not change, and net exports rise by 50.
Option (1) Income rises by 125; net exports rise by 25 — Incorrect. This counts only the rise in exports (2.5 × 50 = 125) and then lets imports rise by 0.2 × 125 = 25. The cut in G cancels the rise in income.
Option (2) Income does not change; net exports do not change — Incorrect. Income is unchanged, but exports are higher by 50 while imports stay the same, so net exports rise.
Option (4) Income falls by 125; net exports rise by 50 — Incorrect. The cut in G and the rise in exports are equal and have the same multiplier, so income does not fall.
NCERT (2026-27): “DETERMINATION OF EQUILIBRIUM INCOME IN OPEN ECONOMY An increase in demand for our exports is an increase in aggregate demand for domestically produced output and will increase demand just as would an increase in government spending or an autonomous increase in investment. …” “… Since m, the marginal propensity to import, is greater than zero, we get a smaller multiplier in an open economy. …” |