NASAA Series 65, Uniform Investment Adviser Law ExaminationEconomic Factors and Business InformationHard
An economist is analyzing the impact of government spending on aggregate demand. According to the Keynesian multiplier effect, if the government increases its spending by $100 billion and the marginal propensity to consume (MPC) is 0.80, what is the total potential increase in aggregate demand?
- A$125 billion
- B$500 billion
- C$180 billion
- D$80 billion
Show answer & explanationAnswer & explanation
Correct answer: B. $500 billion
The spending multiplier is calculated as 1 / (1 - MPC). With an MPC of 0.80, the multiplier is 1 / (1 - 0.80) = 1 / 0.20 = 5. The total potential increase in aggregate demand is the initial spending multiplied by the multiplier: $100 billion * 5 = $500 billion.
Why the other options are wrong
- A. This would be the result if the multiplier was 1.25, which is incorrect.
- C. This incorrectly adds the initial spending to (MPC * initial spending).
- D. This is only the first round of consumption (MPC * initial spending), not the total effect.
Keynesian Multiplier Effect
The idea that an initial change in spending (e.g., government spending, investment) leads to a proportionally larger change in aggregate demand and national income.
- Driven by the marginal propensity to consume (MPC).
- Spending Multiplier = 1 / (1 - MPC).
- A higher MPC leads to a larger multiplier effect.
Memory trick: A ripple in the pond becomes a wave in the economy.