Suppose that Congress allocates $1 billion to clean up after the hurricanes of 2005.It also raises taxes by $1 billion to keep the deficit from growing.If the marginal propensity to consume is 0.9,what is the effect on equilibrium GDP?

Question

Quizplus · Accepted Answer

The increase in government spending (clean up after hurricanes) will lead to an increase in aggregate demand, which will lead to an increase in equilibrium GDP by a multiplier of 1/(1-MPC). In this case, the MPC is 0.9, so the multiplier is 1/(1-0.9) = 10. Thus, an increase in government spending by $1 billion will lead to an increase in equilibrium GDP by $10 billion. However, the tax increase will offset this increase in government spending, so the net effect on equilibrium GDP will only be $1 billion, the initial amount allocated to clean up after the hurricanes. Therefore, the correct answer is D.

Suppose That Congress Allocates $1 Billion to Clean Up After