Question

What is the eventual effect on real GDP if the government increases its purchases of goods and services by $60,000? Assume the marginal propensity to consume (MPC) is 0.75. $_____________________

What is the eventual effect on real GDP if the government, instead of changing its spending, increases transfers by $60,000? Assume the MPC has not changed. $_____________________

An increase in government transfers or taxes, as opposed to an increase in government purchases of goods and services, will result in
a. an identical eventual effect on real GDP.
b. no change to real GDP.
c. a smaller eventual effect on real GDP.
d. a larger eventual effect on real GDP.

Answer 1

$240,000
$180,000
c. a smaller eventual effect on real GDP.

Step-by-step explanation:

The eventual effect on real GDP of an increase in government purchases is the initial increase times the multiplier. The multiplier is

multiplier = 1 / (1−MPC)

where MPC is the marginal propensity to consume. The MPC is the fraction of an additional dollar consumers spend and 0.75 in this question. The eventual effect of the $60,000 increase is

$60000.0 × multiplier = $60000.0 × 1 / (1 − 0.75) = $60000.0 × 4 = $240000

The eventual effect on real GDP if the government increases transfers by $60,000 can be found by multiplying the transfer increase by the MPC and the multiplier.

$60000.0 × multiplier × MPC = $60000.0 × 4 × 0.75 = $180000

This is the same formula as in the case of government spending except for the additional multiplier, the MPC. When the government increases transfer payments, they effectively pay consumers directly, who only spend 75% (their MPC) of the initial $60,000 transfer.

Note that if MPC is equal to 0.5, then the multiplier is equal to 2. So the eventual effect is

$60000.0 × multiplier × MPC = $60000.0 × 2 × MPC = $60000.0 × 2 × 0.5 = $60000.0

In this special case, the eventual impact of a transfer is equal to the size of the transfer.

Unless the MPC is equal to 1, the eventual impact on real GDP for a change in government transfers will be less than the eventual impact for a change in government purchases.