CFA Level IEconomicsMedium
An economy has a marginal propensity to consume (MPC) of 0.75. If the government increases spending by $50 billion, what is the total change in equilibrium GDP, assuming no crowding-out or leakages beyond savings?
- A$250 billion
- B$200 billion
- C$150 billion
- D$175 billion
Show answer & explanationAnswer & explanation
Correct answer: B. $200 billion
The spending multiplier = 1/(1-MPC) = 1/(1-0.75) = 4. Change in GDP = multiplier × change in spending = 4 × $50 billion = $200 billion.
Why the other options are wrong
- A. Overstates the multiplier effect beyond 1/(1-MPC).
- C. Uses an incorrect multiplier below 4.
- D. Does not correspond to the correct multiplier calculation.
Fiscal (Spending) Multiplier
The multiplier effect by which an initial change in government spending leads to a larger change in aggregate output, driven by the marginal propensity to consume.
- Multiplier = 1/(1-MPC) = 1/MPS
- Higher MPC leads to a larger multiplier
- Assumes no crowding out, taxes, or import leakages in simplest form
Memory trick: The bigger the MPC, the bigger the bounce-back spending ripple.