In an open economy, the marginal propensity to consume is 0.8 and the marginal propensity to import is 0.3. Autonomous expenditure is 300. If the marginal propensity to import falls to 0.2 and nothing else changes, what happens to equilibrium income?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → It rises by 150
Imports are a leakage at every round of the multiplier. A lower marginal propensity to import means less of each round’s spending goes abroad, so the multiplier and income rise.
Given:
c = 0.8
m: 0.3 → 0.2
A = 300
\( \displaystyle Y^{*} = \frac{300}{1 - 0.8 + 0.3} = \frac{300}{0.5} = 600 \)
\( \displaystyle Y^{*}_{\text{new}} = \frac{300}{1 - 0.8 + 0.2} = \frac{300}{0.4} = 750 \)
\( \displaystyle \Delta Y = 750 - 600 = 150 \)
Equilibrium income rises by 150, as the multiplier goes up from 2 to 2.5.
Option (1) It rises by 60 — Incorrect. 60 is 0.1 × 600, the drop in imports at the old income. It is not the change in income.
Option (2) It does not change, since autonomous expenditure is the same — Incorrect. Autonomous expenditure is the same, but the multiplier is larger.
Option (3) It falls by 150 — Incorrect. A smaller leakage raises income; it does not lower it.
NCERT (2026-27): “DETERMINATION OF EQUILIBRIUM INCOME IN OPEN ECONOMY If domestic autonomous demand increases by 100, in a closed economy output increases by 500 whereas it increases by only 200 in an open economy. The fall in the value of the autonomous expenditure multiplier with the opening up of the economy can be explained with reference to our previous discussion of the multiplier process (Chapter 4). A change in autonomous expenditures, for instance a change in government spending, will have a direct effect on income and an induced effect on consumption with a further effect on income. With an mpc greater than zero, a proportion of the induced effect on consumption will be a demand for foreign, not domestic goods. Therefore, the induced effect on demand for domestic goods, and hence on domestic income, will be smaller. The increase in imports per unit of income constitutes an additional leakage from the circular flow of domestic income at each round of the multiplier process and reduces the value of the autonomous expenditure multiplier.” “… Since m, the marginal propensity to import, is greater than zero, we get a smaller multiplier in an open economy. …” |