Question

In an economy, the government wants to increase aggregate demand by $50 billion at each price level to increase real GDP and reduce unemployment. If the MPC is 0.6, then it would increase government purchases by:
a. $10 billion.

b. $20 billion.

c. $31.25 billion.

d. $40.50 billion.

Answer 1

Answer:

(B) $20 billion

Explanation:

Given a certain level of MPC, an increase in government spending (G) by a certain amount translates to an increase in aggregate demand (AD) through the relationship below.

$ΔAD = \frac{ΔG}{1 - MPC}$

where Δ means change.

Therefore, given ΔAD of $50 billion, and MPC of 0.6,

$ΔAD = \frac{ΔG}{1 - MPC}$

= $50 = \frac{ΔG}{1 - 0.6}$

= $50 = \frac{ΔG}{0.4}$

= ΔG = 50 * 0.4 = 20

Therefore, increase in government purchases = $20 billion.