If the marginal propensity to consume is 0.8 and the proportional income tax rate is 0.25, by how much would the equilibrium level of real GDP demanded increase if government purchases rose by $50 billion?
A)$50 billion
B)$100 billion
C)$500 billion
D)$125 billion
E)$275 billion

Question

Quizplus · Accepted Answer

The multiplier formula is: 
1 / (1 - MPC x (1 - proportional tax rate))
= 1 / (1 - 0.8 x 0.75)
= 1 / 0.35
= 2.86

Therefore, an increase in government purchases by $50 billion will result in an increase in real GDP demanded by:
$50 billion x 2.86 = $143 billion
However, we need to adjust this by the proportional tax rate: 
$143 billion x (1 - 0.25) = $107 billion

Therefore, the equilibrium level of real GDP demanded would increase by $107 billion. The closest answer choice is D) $125 billion.

If the Marginal Propensity to Consume Is 0