Other things equal, if $100 billion of government purchases (G) is added to private spending (C + Ig + Xn), GDP will
A) increase by $100 billion.
B) increase by less than $100 billion.
C) increase by more than $100 billion.
D) fall by $100 billion.

Question

Quizplus · Accepted Answer

When government purchases (G) are added to private spending (C + Ig + Xn), the resulting increase in aggregate demand causes an increase in GDP. However, the full extent of the impact on GDP depends on the magnitude of the multiplier effect.

The multiplier effect refers to the impact that an initial change in spending has on overall economic activity. When government purchases increase, this leads to an increase in overall demand in the economy, which can lead to an increase in production, employment, and income. This increase in income, in turn, can lead to additional increases in spending, further increasing the impact on GDP.

The size of the multiplier effect depends on various factors, including the marginal propensity to consume (MPC) and the marginal propensity to import (MPI). On average, the multiplier effect is believed to be between 1.5 and 2.0, which means that an initial increase in government purchases of $100 billion could lead to an increase in GDP of $150-$200 billion. Therefore, the correct answer is C, which states that GDP will increase by more than $100 billion.

Other Things Equal, If $100 Billion of Government Purchases (G)