Suppose that the government allocates $1 billion for new roads.It also raises taxes by $1 billion to keep the deficit from growing.If the marginal propensity to consume = 0.9,what is the effect on equilibrium GDP?

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) tells us how much of each additional dollar of income people will spend. In this case, if the government spends $1 billion on new roads, then people will spend 0.9 x $1 billion = $900 million of that on other goods and services. This additional spending will increase GDP by $1 billion (the amount the government spent), plus $900 million (the additional spending by consumers), for a total increase in GDP of $1.9 billion. However, the government raised taxes by $1 billion, which will decrease consumer spending by 0.9 x $1 billion = $900 million. This decrease in consumer spending will offset the increase in spending from the government, resulting in a net increase in GDP of $1 billion. Therefore, the correct answer is D.

Suppose That the Government Allocates $1 Billion for New Roads