Surge in government demand (G) discourages some private demand (I) and this is a major reason as to why the oversimplified formula: 1/(1-MPC) ____________ the size of the multiplier.

Question

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When there is a surge in government demand (G), it leads to a decrease in private demand (I) as resources are diverted towards fulfilling the government demand. This leads to a reduction in the marginal propensity to consume (MPC) and an increase in the marginal propensity to save (MPS). The oversimplified formula: 1/(1-MPC) assumes that there is no impact of government demand on private demand, which is not the case in reality. Therefore, this formula exaggerates the size of the multiplier.

Surge in Government Demand (G) Discourages Some Private Demand (I)