Question

If the marginal propensity to consume is 0.2 and investment increases by $40, by how much will equilibrium GDP increase?

Answer 1

The equilibrium GDP will increase by $50.

Step-by-step explanation:

The marginal propensity to consume (MPC) is the proportion of an increase in income that is spent on consumption. In this case, the MPC is 0.2, which means that for every $1 increase in income, $0.20 will be spent on consumption.

If investment increases by $40, the spending multiplier can be calculated as 1 / (1 - MPC) = 1 / (1 - 0.2) = 1 / 0.8 = 1.25.

To determine the increase in equilibrium GDP, we multiply the change in investment by the spending multiplier: $40 * 1.25 = $50. Therefore, the equilibrium GDP will increase by $50.