Suppose that the government allocates $2 billion for new roads. It also raises taxes by $2 billion to keep the deficit from growing. If the marginal propensity to consume = 0.8, what is the effect on equilibrium GDP?
A)GDP does not change
B)GDP increases by $5 billion
C)GDP increases by $800 million
D)GDP increases by $2 billion

Question

Quizplus · Accepted Answer

The $2 billion increase in government spending on new roads will directly increase GDP by the same amount. Additionally, the increase in taxes will decrease disposable income by $2 billion, but since the marginal propensity to consume is 0.8, consumers will spend 80% of the remaining $2 billion. Therefore, the total increase in GDP will be $2 billion from the government spending, plus 0.8($2 billion) from the increase in consumer spending, for a total increase of $3.6 billion.

Suppose That the Government Allocates $2 Billion for New Roads