The Multiplier Effect: How Government Spending Impacts Real GDP

How does an increase in government spending impact real GDP?

If government spending increases by $900 million and the marginal propensity to consume is 0.8, what will be the resulting change in real GDP?

Impact of Government Spending on Real GDP

When government spending increases, it can have a significant impact on the overall economy, particularly on the nation's real Gross Domestic Product (GDP). By analyzing the multiplier effect and considering the marginal propensity to consume (MPC), we can calculate the extent of this impact.

The multiplier effect is a concept that illustrates how an initial increase in spending by the government leads to subsequent rounds of spending throughout the economy. This effect is determined by the marginal propensity to consume, which indicates the portion of additional income that individuals spend rather than save.

The formula to calculate the multiplier effect is:

Multiplier = 1 / (1 - MPC)

Given that the marginal propensity to consume (MPC) is 0.8, we can calculate the multiplier:

Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

Therefore, the multiplier in this scenario is 5. To determine the increase in real GDP resulting from the $900 million increase in government spending, we can use the following calculation:

Increase in real GDP = Increase in government spending * Multiplier = $900 million * 5 = $4.5 billion

Hence, if government spending rises by $900 million and the marginal propensity to consume is 0.8, the real GDP will increase by $4.5 billion.