You are given the following data for national economy of a country Y:

Equilibrium GDP is $6000 million.

MPC is 0.8

It is considered to be necessary to increase GDP by 5%. Find what amount of additional government spending (without changing taxes) would be needed to reach the desired increase of GDP?

Solution

A 5% increase in GDP which is currently $6,000,000,000 would be $300,000,000. A 5% increase in GDP would require less than a 5% increase in spending due to the multiplier effect. Every dollar of government spending will be spent and re-spent in the circular flow of economic activity. For example, if road construction is authorized, government spending for materials and workers will be spent again by the materials suppliers and the hired workers. Thus, the boost to the economy will be more than 5%. If the MPC (Marginal Propensity to Consume) is .8, then the MPS (Marginal Propensity to Save) must be .2, because together the percentages must add up to 1. Thus, the spending multiplier is 1 / (1 - MPC). In this example, it would be 1 / .2 or 5. That means that each dollar of government spending will generate 5 times that much GDP. To increase GDP by $300,000,000, therefore would take an increase of $300,000,000/5 or $60 million.