Question

The Government has been providing payment support for those affected by COVID-19. Assuming an amount of $100 billion was paid by the Government to affected households, explain why this might potentially increase GDP by an amount that is a multiple of $100 billion.

Include the following in your answer,

a) definition of marginal propensity to consume (mpc),

b) definition of marginal propensity to save (mps),

c) the spending multiplier formula,

d) why the increase in GDP may potentially be greater than $100 billion.

Answer 1

a) The marginal propensity to consume (MPC) is the proportion of an increase in income that a household spends on consumption.

b) The marginal propensity to save (MPS) is the proportion of an increase in income that a household saves.

c) The spending multiplier formula is 1/(1-MPC). This formula shows that an increase in government spending will have a multiplied effect on GDP.

d) The increase in GDP may potentially be greater than $100 billion because of the spending multiplier effect. When the government provides payment support to affected households, this increases their disposable income. This increase in disposable income leads to an increase in consumption spending, which in turn leads to an increase in production and income. The increase in production and income leads to further increases in consumption spending, and this cycle continues. The spending multiplier formula shows that the total increase in GDP is equal to the initial increase in government spending multiplied by the spending multiplier. In this case, assuming an MPC of 0.8, the spending multiplier is 5. Therefore, the increase in GDP would be $500 billion, which is a multiple of the $100 billion paid by the government.