Question

Assume that Equilibrium GDP is $4,000 billion. Potential GDP is $5,000 billion. The marginal propensity to consume is 4/5 (0.8). By how much and in what direction should government purchases be changed?

Group of answer choices

increase by $200 billion

increase by $1,000 billion

decrease by $1,000 billion

increase by $100 billion

Answer 1

Increase by $200 billion.

​​​​​​Marginal propensity to consume (MPC) = 0.8

Spending multiplier = 1/(1-MPC) = 1/0.2 = 5

So, an increase of $1 of government purcahses will increase the GDP by 5*$1 = $5.

So a $2 increase in government purcahses will lead to an increase of $5 of GDP.

Equilibrium GDP is $4000 billion and potential GDP is $5000 billion. So, the economy can still increase its GDP by $1000 billion.

We have seen that a $1 increase in government purcahses will increase GDP by $5.

So, to raise $1000 billion in GDP, the government has to increase its purcahses by $1000b/5 = $200 billion.

Therefore, the required action is to increase government purchases by $200 billion.

This action will lead the economy to its potential GDP.