Suppose that MPC = 0.7 and MPI = 0.2. According to the Keynesian multiplier, a decrease of $20 million in government purchases will
A)increase real GDP by $40 million.
B)decrease real GDP by $40 million.
C)increase real GDP by $100 million.
D)decrease real GDP by $100 million.
E)have no impact on real GDP.

Question

Quizplus · Accepted Answer

The Keynesian multiplier formula is 1/(1-MPC). With an MPC of 0.7, the multiplier is 1/(1-0.7) = 3.33. A decrease in government purchases of $20 million will lead to a decrease in aggregate demand by $20 million. With the multiplier effect, this decrease in aggregate demand will lead to a decrease in real GDP of $20 million x 3.33 = $66.6 million. Since the question asks for the change in real GDP, and the change is negative, the correct answer is B, decrease real GDP by $40 million (the closest option).

Suppose That MPC = 0