Question

The U.S economy slowed significantly in early 2008, and policy makers were extremely

concerned about growth. To boost the economy the government decided to increase

government spending by $700 billion (government consumption) (20 Points)

a. Calculate the resulting change in real GDP arising from the $700 billion in

governments spending if the marginal propensity to consume is 0.5. Explain why the

GDP increases by more than $700 billion.

b. How would the result (change in GDP) change if the marginal propensity to consume

would be higher or lower? Explain your answer.

c. Would the change in GDP be different if the government would have increased

transfer payments instead of government spending to react to the recession? Explain

your answer.

Answer 1

a. Government spending increased by $700 billion.

Marginal propensity to consume = 0.5

Real GDP arising = (0.5*700) + 700= $1050 billion.

Government spending increases the disposable income of American consumers.

b. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment; so, if economist can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in incomes. And the vice versa is true.

c. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment; so, if economist can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in incomes