Question

During a recession, the government spends $100 million to stimulate the economy. If the marginal propensity to consume is 0.8, what will be the potential increase in income in the economy as a result of the government increase in the spending level

Answer 1

Potential increase in income = $500 million

Step-by-step explanation:

Expenditure Multiplier is the amount by which the real GDP will change if autonomous expenditure changes by a given amount.

The real GDP will change in greater proportion or magnitude as a result of a unit change in any of the component aggregate expenditure. This is called the multiplier effect

The expenditure multiplier is calculated as follows: 1/(1-MPC).

MPC is the portion of additional income that is spent. If the MPC is 0.8, then the expenditure multiplier will be = 1/(1-0.8) = 5

Using the with an date from the question in government spending by $million, the resulting change in GDP would be

Change in GDP = change in autonomous expenditure × Multiplier

= 100 × 5 = $500 million

Potential increase in income = $500 million