Consider an economy whose households save 20% of increases in their income. If the government lowers its transfers by $100 billion, then the real GDP will:
A)decrease by $125 billion.
B)decrease by $400 billion.
C)increase by $125 billion.
D)decrease by $500 billion.

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) is 0.8 (since households save 20%). The spending multiplier is 1/(1-MPC) = 5. A $100 billion decrease in transfers reduces consumption by $80 billion (MPC * $100 billion), leading to a total GDP decrease of $80 billion * 5 = $400 billion.

Consider an Economy Whose Households Save 20% of Increases in Their