Question

Suppose that the MPC = 0.75 and the MPIM = 0.15. Full employment real GDP is equal to $1000 million and actual real GDP is $750 million. What change in government spending is necessary to bring the economy to full employment?

• A. change in G = $100 million
• B. change in G = $200 million
• C. change in G = $250 million
• D. change in G = $625 million
• E. change in G = $1250 million

Answer 1

Actual GDP = 750 million and Full employment GDP = 1000 million. Thus we want to increase GDP by 1000 million - 750 million = 250 million.

Multiplier = 1/(1 - MPC + MPIM) = 1/(1 - 0.75 + 0.15) = 2.5 where MPIM = Marginal propensity to import and MPC = Marginal propensity to consume.

=> Multiplier = 2.5.

This means that $1 increase in autonomous expenditure(like Government spending(G)) will result in increase in Real GDP by $2.5. Thus In order to increase Real GDP by $250 million we have to increase G by (1/2.5)*250 million = 100 million.

Hence Change in G = 100 million in order to acheive full employment level of output.

Hence, the correct answer is (A) change in G = $100 million.