Assume that the marginal propensity to consume is 0.8 and potential output is $800 billion. If real GDP is $850 billion, to bring the economy to potential output the government should:
A)decrease spending by $50 billion.
B)increase spending by $50 billion.
C)decrease transfers by $50 billion.
D)decrease spending by $10 billion.

Question

Quizplus · Accepted Answer

The spending multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. To reduce GDP by $50 billion to reach potential output, the government should decrease spending by $10 billion, as $10 billion * 5 = $50 billion.

Assume That the Marginal Propensity to Consume Is 0