Final answer:
A $100 billion increase in government spending with a spending multiplier of 1.2 results in a $120 billion increase in GDP, due to the multiplier effect which circulates spending through the economy in diminishing cycles.
Step-by-step explanation:
If the spending multiplier is 1.2, then a $100 billion increase in government spending will increase GDP by $120 billion. This calculation is based on the multiplier effect, which in economic terms refers to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of spending. The formula to calculate the impact on GDP is simply the change in spending multiplied by the multiplier. In this case, $100 billion multiplied by 1.2 equals $120 billion increase in GDP.
As an analogy, the multiplier effect is like a stone thrown into a pond, which creates ripples. Each ripple represents the cycles of spending that follow the initial spending. Therefore, the increase in government spending continues to have an impact as it circulates through the economy, with each round's impact decreasing slightly. This concept is instrumental in understanding how fiscal policy can influence economic growth.