If the government increases its purchases by $100 and the multiplier is 4,then equilibrium real GDP demanded
A)increases by $25
B)decreases by $25
C)increases by $100
D)increases by $400
E)decreases by $400

Question

Quizplus · Accepted Answer

The multiplier effect states that an initial increase in government purchases will lead to a multiplied increase in equilibrium real GDP. The size of the multiplier is determined by the marginal propensity to consume (MPC), which is the fraction of an additional dollar of income that is spent on consumption. Assuming an MPC of 0.75 (typical for economies such as the US), a $100 increase in government purchases would result in an initial increase in aggregate demand of $100, which would increase disposable income by $75 (since 25% would go to taxes). This $75 would then be spent, leading to an additional increase in aggregate demand of $75 x 0.75 = $56.25. This process of spending and re-spending continues until the increase in aggregate demand becomes $400, which is 4 times the initial increase in government purchases of $100. Therefore, equilibrium real GDP demanded would increase by $400.

If the Government Increases Its Purchases by $100 and the Multiplier