When an economy is operating well below its full-employment capacity and the marginal propensity to consume is 0.75, a $10 billion increase in investment spending will cause the equilibrium output to rise by:
A) $5 billion.
B) $10 billion.
C) $20 billion.
D) $40 billion.

Question

Quizplus · Accepted Answer

The multiplier effect formula is 1/(1-MPC), where MPC is the marginal propensity to consume. Here, MPC = 0.75, so the multiplier is 1/(1-0.75) = 4. A $10 billion increase in investment spending will therefore increase the equilibrium output by 10 billion * 4 = $40 billion.

When an Economy Is Operating Well Below Its Full-Employment Capacity