If the spending multiplier equals 5 and equilibrium income is $2 billion below potential GDP, then _____ to reach the potential real GDP level.

Question

Quizplus · Accepted Answer

The spending multiplier represents the magnifying effect of an initial change in spending on the overall income in an economy. Therefore, if the spending multiplier is 5, a change in spending of $1 billion will result in a $5 billion change in the equilibrium income.

In this case, the equilibrium income is $2 billion below potential GDP, which means that there is a shortfall in spending. To reach the potential real GDP level, total spending needs to be increased by $2 billion. Using the spending multiplier, we can calculate the required increase in spending as follows:

Increase in spending = spending multiplier x change in income
$2 billion = 5 x change in income
Change in income = $2 billion / 5
Change in income = $0.4 billion

Therefore, the total spending needs to be increased by $0.4 billion to reach the potential real GDP level. The correct answer is E.

If the Spending Multiplier Equals 5 and Equilibrium Income Is