Question

Suppose that the economy is at equilibrium at $1,000 billion, and potential output is $1,200 billion. If the marginal propensity to consume (MPC) is 0.9, then government spending must increase by $_____ billion to reach potential output.

Answer 1

20

Step-by-step explanation:

The computation of the increase in the government spending is shown below:

= (Economy is at equilibrium point - potential output) ÷ (Multiplier)

= ($1,000 billion - $1,200 billion) ÷ (10)

= $200 billion ÷ 10

= $20 billion

The multiplier is computed below:

= (1) ÷ (1 - MPC)

= (1) ÷ (1 - 0.9)

= 1 ÷ 0.1

= 10

We simply first apply the multiplier formula, than calculate the government spending increment