Suppose that marginal propensity to consume is equal to 0.9 and the government increases its spending by $200 billion. This increase in spending is financed by a $200 billion increase in taxes. As a result of this, GDP will:
A)not change at all.
B)decrease by $200 billion.
C)increase by $2,000 billion.
D)increase by $200 billion.

Question

Quizplus · Accepted Answer

The marginal propensity to consume is defined as the fraction of each additional dollar of disposable income that is spent on consumption. Here, the marginal propensity to consume is 0.9, which means that if households receive an additional $1 of income, they will spend $0.9 of it on consumption.

When the government increases its spending by $200 billion, it injects $200 billion of additional spending into the economy. This additional spending will increase the income of those who receive it, leading to an increase in consumption spending. Based on the marginal propensity to consume of 0.9, we would expect that $180 billion ($200 billion x 0.9) of the additional income will be spent on consumption. This increase in consumption spending will lead to an increase in GDP.

At the same time, the government also increases taxes by $200 billion to finance the increase in spending. This decrease in income will reduce consumption spending, leading to a decrease in GDP. However, the decrease in consumption spending is expected to be smaller than the increase in consumption spending due to the additional income from government spending, so we would still expect an overall increase in GDP.

Therefore, the correct answer is D, GDP will increase by $200 billion.

Suppose That Marginal Propensity to Consume Is Equal to 0