Question

Suppose that there is an increase in government spending of $10 billion, and that the government spending multiplier is 1.5. Does real GDP increase or decrease? by how much?

Answer 1

An increase in government spending of $10 billion with a multiplier of 1.5 leads to an increase in real GDP by $15 billion due to the multiplier effect.

Step-by-step explanation:

When there is an increase in government spending of $10 billion with a government spending multiplier of 1.5, the real GDP increases. This is because of the multiplier effect, which implies that every dollar spent by the government results in a greater than one-dollar increase in aggregate demand due to subsequent rounds of spending within the economy. To determine the total impact on the real GDP, we multiply the change in government spending by the multiplier: $10 billion × 1.5 = $15 billion.

The increase in government spending triggers additional rounds of income and consumption, leading to a greater increase in overall economic activity. Households receiving the government spending as income will spend most of it after paying taxes, saving a portion, and buying imports. The remaining is spent mostly on domestically produced goods and services, cycling through the economy and creating additional demand. Thus, the real GDP increases by the total change in aggregate demand, which in this case, is $15 billion.