Suppose real GDP is $800 billion when the MPC is 0.80, and people decide to increase their saving by $30 billion. Before this change, the economy was in equilibrium with people intending to save $100 billion and producers intending to invest $100 billion. The new equilibrium level of real GDP is:
A) $600 billion.
B) $650 billion.
C) $680 billion.
D) $730 billion.

Question

Quizplus · Accepted Answer

Before the change, people intended to save $100 billion, while producers intended to invest $100 billion. This created a balance that led to an equilibrium level of real GDP at $800 billion.

When people decide to increase their saving by $30 billion, the total saving increases to $130 billion. Since the MPC is 0.8, this change in savings will lead to a decrease in consumption spending of $24 billion (0.8 x $30 billion).

The decrease in consumption spending will lead to a decrease in aggregate demand, which will lead to a decrease in real GDP. The equation that shows the relationship between changes in autonomous spending, the multiplier, and changes in real GDP is:

change in real GDP = (1 / (1 - MPC)) x change in autonomous spending

Plugging in the numbers:

change in real GDP = (1 / (1 - 0.8)) x (- $24 billion)
change in real GDP = 5 x (- $24 billion)
change in real GDP = - $120 billion

Therefore, the new equilibrium level of real GDP will be:

$800 billion - $120 billion = $680 billion.

So, the correct answer is B.

Suppose Real GDP Is $800 Billion When the MPC Is