If the income-expenditure multiplier equals 2.5 and a 1 percentage point increase in the real interest rate reduces autonomous spending by 200 units, then a 1,000 unit expansionary gap can be eliminated by ______ the real interest rate by ______ percentage points.

Question

Quizplus · Accepted Answer

The income-expenditure multiplier (k) is equal to 2.5, which means that a $1 increase in autonomous expenditure leads to a $2.5 increase in real GDP.

A 1 percentage point increase in the real interest rate reduces autonomous spending by 200 units, which implies that the marginal propensity to import (MPC) is 0.2. This is because a 1% increase in the real interest rate decreases consumption and investment spending, and therefore net exports must increase by 200 units to maintain equilibrium. If net exports increase by 200 units when GDP increases by $500 (i.e. 2.5 x $200 units), then the MPC is 0.2 ($200/$1000).

To eliminate a 1,000 unit expansionary gap, the reduction in autonomous spending needs to be $1000/2.5, which is $400. This requires a 2 percentage point increase in the real interest rate, which corresponds to choice C (increasing the real interest rate by 2.0 percentage points).

If the Income-Expenditure Multiplier Equals 2