Question

If the MPC is 0.8 and a component of AD, such as Investment, is increased by $5, then the maximum amount of change in income and output for the nation would be ___________ .
a. $20
b. $25
c. $50
d. $100

Answer 1

Answer:

$25

Explanation:

The maximum amount by which the real GDP is expected to change for a given change in expenditure is known as the multiplier. Note that an economy is made of millions of economic agents interacting with one another. So expenditure made by one actor becomes an income in the hands of another who in turn spends a portion which becomes income to another and so on.

Marginal propensity to consume (MPC) represents the proportion of any extra income spent. For example, if my income increases by $100 and I only spent $70, then MPC is 0.7.

The multiplier depends on MPC. The multiplier is calculated as follows

Multiplier = 1/(1-MPC)

The multiplier in this question is therefore equals to 1/(1-0.8) = 5.

The maximum change expected in the real GDP is calculated as follows:

Maximum change change in GDP = Multiplier × change in expenditure

The maximum change in output for this question is

1/(1-0.8) × $5 = $25