Question

Refer to the previous question, in which households spend $0.60 of each additional dollar they earn and save the remaining $0.40. Suppose the government in this economy decides to increase government purchases (G) by $400 billion. The total change in demand resulting from the initial change in G is____? [Hint: use the spending multiplier formula]

Answer 1

Answer:

$1,000 billion

Explanation:

Given that,

Households spends = $0.60 of each additional dollar they earn

Save remaining = $0.40

Increase in government purchases = $400 billion

Therefore, the marginal propensity to consume is calculated as follows:

= Change in consumption ÷ Change in income

= $0.60 ÷ $1

= 0.60

Now, we need to find out the spending multiplier,

= 1 ÷ (1 - MPC)

= 1 ÷ (1 - 0.60)

= 1 ÷ 0.40

= 2.5

Therefore, the total change in demand resulting from the initial change in government purchases is calculated as follows:

= Change in government purchases × Spending multiplier

= $400 billion × 2.5

= $1,000 billion