If the marginal propensity to consume is 0.95 and government spending falls by $200, then equilibrium output on the Keynesian cross diagram (for a fixed interest rate) rises by
A) $180.
B) $200.
C) $380.
D) none of the above.

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) being 0.95 implies that for every dollar decrease in income, consumption decreases by 95 cents. If government spending falls by $200, it would initially reduce the equilibrium output by more than $200 due to the multiplier effect. The multiplier is 1/(1-MPC) = 1/(1-0.95) = 20. Therefore, a $200 decrease in government spending would reduce the equilibrium output by $200 * 20 = $4000, not increase it. None of the provided options correctly describes this outcome.

If the Marginal Propensity to Consume Is 0