The Prime Minister of Richlandia hires you as an economic consultant. He is concerned that the output level in Richlandia is too low and that this will cause unemployment to rise. He feels that it is necessary to increase output by $20 billion. He tells you that the MPC in Richlandia is 0.75. Which of the following would be the best advice to give to the Richlandian Prime Minister?

Question

Quizplus · Accepted Answer

The best advice to give to the Richlandian Prime Minister would be to increase government purchases in Richlandia by $5 billion. The reason for this is that the multiplier effect of government spending is greater than the multiplier effect of a tax cut, given the MPC in Richlandia. The formula for the multiplier effect is: 1/(1-MPC). In this case, the multiplier effect of a government purchase is 4 (1/(1-0.75)), whereas the multiplier effect of a tax cut is only 3. Therefore, an increase in government purchases of $5 billion would lead to an increase in output of $20 billion (4 x $5 billion) - which is the desired outcome.

The Prime Minister of Richlandia Hires You as an Economic