Question

Our economists have redone their

calculations. They now estimate that
citizens in our country have an MPC
of 0.75. We can fix the problem by
decreasing GDP by $1,000.
How much should we decrease
government spending?

Answer 1

To decrease GDP by $1,000 with an MPC of 0.75, the government should reduce spending by $250, accounting for the fiscal multiplier of 4.

Step-by-step explanation:

To determine how much government spending should be decreased to reduce GDP by $1,000 when the marginal propensity to consume (MPC) is 0.75, we need to calculate the fiscal multiplier. The formula for the fiscal multiplier is 1/(1-MPC). Given an MPC of 0.75, the multiplier would be 4. As a result, to decrease GDP by $1,000, the government would need to reduce spending by the inverse of this amount divided by the fiscal multiplier, which equates to a reduction in government spending by $250.

Government spending, MPC, and GDP are closely linked through the multiplier effect. A decrease in government spending will lead to a larger change in GDP, which is why it is crucial to apply the correct multiplier when policy adjustments are considered.