Question

The marginal propensity to consume (MPC) is 0.8 and government spending decreases by $1 trillion. In this case, the real GDP will decrease by $_____ trillion from the initial effect of the decrease in government spending, and $_____ trillion from the decrease in consumption.

Answer 1

The correct answer is: $1 trillion; $4 trillion.

Step-by-step explanation:

The marginal propensity to consume is 0.8.

Government spending decreases by $1 trillion.

The real GDP will initially decline by the amount of decline in government spending.

So the decline in the real GDP will initially be $1 trillion.

The overall decrease in the real GDP will be by the size of the spending multiplier.

Total decrease in real GDP

=
`\Delta G * (1)/(1-MPC)`

=
`\$ 1*(1)/(1-0.8)`

=
`\$1 * (1)/(0.2)`

= $5 trillion

Out of this $5 trillion decrease, $1 was initially decreased.

So decline in real GDP due to reduced consumption will be

= $5 trillion - $1 trillion

= $4 trillion