Suppose that Congress allocates $1 billion to clean up after hurricanes in 2018.It also raises taxes by $1 billion to keep the deficit from growing.If the marginal propensity to consume is 0.9,what is the effect on equilibrium GDP?
A)GDP does not change.
B)GDP increases by $10 billion.
C)GDP increases by $900,000.
D)GDP increases by $1 billion.

Question

Quizplus · Accepted Answer

The government's action of allocating $1 billion for hurricane clean-up will increase aggregate demand in the economy. Assuming a marginal propensity to consume of 0.9, the initial increase in government spending will cause a total increase in aggregate demand by $10 billion (1 / (1 - 0.9)). Since taxes have been raised by $1 billion, the net increase in aggregate demand will be $9 billion. Therefore, equilibrium GDP will increase by $1 billion (equal to the initial increase in government spending) due to the multiplier effect.

Suppose That Congress Allocates $1 Billion to Clean Up After