Suppose the marginal propensity to consume is 0.8 and the government cuts taxes by $40 billion. Real GDP will _____ by _____.
A)increase; $200 billion
B)decrease; $200 billion
C)increase; $160 billion
D)decrease; $160 billion

Question

Quizplus · Accepted Answer

The formula to calculate the change in real GDP is MPC x tax cut. In this case, MPC is 0.8 and the tax cut is $40 billion, therefore the change in real GDP would be 0.8 x $40 billion = $32 billion. However, since the question asks for the change in real GDP and not the change in disposable income, we need to use the multiplier formula to get the final answer. The multiplier formula is 1/MPS, where MPS is the marginal propensity to save. Since MPC + MPS = 1, MPS must be 0.2 in this case. Therefore, the multiplier is 1/0.2 = 5. Using the multiplier, we can calculate the change in real GDP as $32 billion x 5 = $160 billion. Thus, the correct answer is C.

Suppose the Marginal Propensity to Consume Is 0