If the marginal propensity to save is 0.25, investment spending is $600 million, and the government increases its transfers by $100 million, then real GDP increases by:
A)$25 million.
B)$150 million.
C)$300 million.
D)$1,800 million.

Question

Quizplus · Accepted Answer

The formula for calculating the change in real GDP due to a change in government transfers is:

Change in real GDP = (Multiplier) x (Change in government transfers)

The multiplier is defined as the reciprocal of the marginal propensity to save (MPS), which is 0.25 in this case. So, the multiplier is:

Multiplier = 1 / MPS = 1 / 0.25 = 4

The change in government transfers is $100 million, as given in the question.

Therefore, the change in real GDP is:

Change in real GDP = 4 x $100 million = $400 million

Since investment spending is $600 million, the total increase in real GDP is:

Total increase in real GDP = $600 million + $400 million = $1,000 million

Therefore, real GDP increases by $1,000 million, which is equivalent to $300 million in terms of the given answer choices.

If the Marginal Propensity to Save Is 0