Suppose equilibrium real GDP is currently at $800 billion and investment is $100 billion. If an increase in the interest rate reduces investment from $100 billion to $75 billion, and the MPC is 0.8, the new level of equilibrium real GDP will be:
A) $500 billion.
B) $600 billion.
C) $675 billion.
D) $775 billion.

Question

Quizplus · Accepted Answer

A decrease in investment from $100 billion to $75 billion results in a decrease in aggregate demand, causing a decrease in equilibrium real GDP. Using the formula for the spending multiplier, we find that the change in equilibrium real GDP is equal to:
ΔY = -∆I / (1 - MPC)
ΔY = -($25 billion) / (1 - 0.8)
ΔY = -$25 billion / 0.2
ΔY = -$125 billion
Therefore, the new level of equilibrium real GDP will be:
Y = $800 billion - $125 billion
Y = $675 billion.

Suppose Equilibrium Real GDP Is Currently at $800 Billion and Investment