The Impact of Government Purchases on GDP

What is the effect of an increase in government purchases on GDP?

Choose one:

A. $8.3 billion

B. $3 billion

C. $1.25 billion

D. $30 billion

E. $12.5 billion

Answer:

The effect of an increase in government purchases on GDP is $12.5 billion.

When the marginal propensity to consume (MPC) is 0.6 and government purchases increase by $5 billion, the resulting impact on GDP is $12.5 billion. This means that for every dollar increase in government purchases, GDP is expected to increase by $12.5 billion. The formula used to calculate this change in GDP due to an increase in government purchases is:

ΔGDP = (ΔGovernment Purchases) / (1 - MPC)

Given the MPC of 0.6 and the $5 billion increase in government purchases, we substitute these values into the formula:

ΔGDP = ($5 billion) / (1 - 0.6)

= $5 billion / 0.4

= $12.5 billion

Therefore, the correct answer is $12.5 billion. This indicates the significant impact that government spending can have on the overall GDP of a country.