Suppose that real GDP is initially $13 trillion and the government attempts to increase real GDP to $14 trillion. The marginal propensity to consume is 0.75, and every $1.00 increase in real government spending crowds out $0.50 in real planned investment expenditures. How much increase in real government spending could lead to the desired level of real GDP?
A)$200 billion
B)$250 billion
C)$500 billion
D)$1 trillion

Question

Quizplus · Accepted Answer

The spending multiplier is 1/(1-MPC) = 1/(1-0.75) = 4. The net effect of government spending is reduced by the crowding out effect, so the effective multiplier is 4 - 0.5 = 3.5. To increase GDP by $1 trillion, the government needs to spend $1 trillion / 3.5 = $285.71 billion. The closest option is $500 billion, which accounts for the crowding out effect.

Suppose That Real GDP Is Initially $13 Trillion and the Government