Suppose that the government is debating an increase in expen

Suppose that the government is debating an increase in expenditures equal to $5 billion dollars. Assume that the marginal propensity to consume (MPC) is equal to 0.90. According to Keynesian theory, all other things being equal, how large of an increase in GDP would you expect if the extra government spending is approved?

A) $50 billion

B) $5.55 billion

C) $4.5 billion

D) $0.5 billion

Solution

Change in equilibrium output (GDP) = spending multiplier x change in investment expenditure.

Rewritten, Change in GDP = 1/(1-0.90) x $5 billion = 10*$5 billion = $50 billion