- To close a recessionary gap of $500 billion, a government is considering fiscal policy. The marginal propensity to consume is 0.75. Assuming no crowding out or changes in the price level, which policy would achieve this goal?
Answer: Increasing government spending by $125 billion.
First, calculate the expenditure and tax multipliers. The expenditure multiplier is 1/(1−MPC)=1/(1−0.75)=4. The tax multiplier is −MPC/(1−MPC)=−0.75/0.25=−3. To increase GDP by $500 billion with government spending, the required change is ΔY/MG=$500 billion/4=$125 billion. To achieve the same goal with a tax cut, the required change is ΔY/MT=$500 billion/−3≈−$167 billion (a decrease of $167 billion). Therefore, increasing government spending by $125 billion is the correct policy action among the choices. - Assume the government spending multiplier is 4. If a government increases its spending by $100 billion and this action leads to an increase in the price level, the resulting increase in real GDP will be
Answer: less than $400 billion.
The spending multiplier of 4 calculates the maximum potential change in real GDP, assuming a constant price level. This corresponds to the full horizontal shift of the Aggregate Demand curve. However, when the price level increases (due to an upward-sloping SRAS curve), wealth, interest-rate, and exchange-rate effects cause a movement up along the new AD curve. This dampens the final increase in real output. Therefore, the actual increase in real GDP will be less than the $400 billion predicted by the simple multiplier.
- An economy has a marginal propensity to consume of 0.8 and a proportional income tax rate of 20%. The government increases its spending by $100 billion, financed by borrowing. By how much does the government's budget deficit increase?
Answer: It increases by approximately $44.4 billion.
The deficit increases by the change in government spending (ΔG) minus the change in tax revenue (ΔT). Initially, ΔG=+$100 billion. This spending increases GDP, which induces more tax revenue. The multiplier is 1/(1−MPC(1−t))=1/(1−0.8(1−0.2))=1/(1−0.64)=1/0.36. The change in GDP is ΔY=(1/0.36)×$100 billion. The change in tax revenue is ΔT=t×ΔY=0.20×(1/0.36)×$100 billion≈$55.6 billion. The net change in the deficit is ΔG−ΔT=$100 billion−$55.6 billion≈$44.4 billion. - In an economy with a marginal propensity to save of 0.25, autonomous consumption decreases by $10 billion while autonomous investment increases by $30 billion. What is the net effect on the equilibrium level of real GDP?
Answer: An increase of $80 billion
First, determine the spending multiplier. If MPS = 0.25, the multiplier is 1/MPS=1/0.25=4. Next, determine the net initial change in autonomous spending. The decrease in autonomous consumption (−$10 billion) and the increase in autonomous investment (+$30 billion) result in a net initial increase of $20 billion. Finally, multiply the net initial change by the multiplier: 4×$20 billion=$80 billion. Real GDP will increase by $80 billion. - An economy has a spending multiplier of 2.5 and experiences a simultaneous $40 billion increase in exports and a $25 billion increase in imports. Assuming these are autonomous changes, what is the net effect on equilibrium GDP?
Answer: GDP increases by $37.5 billion from the net trade balance improvement
Exports act like autonomous spending increases, while imports act like leakages (similar to saving). The export increase of $40B creates a positive effect: $40B × 2.5 = $100B increase in GDP. The import increase of $25B creates a negative effect: $25B × 2.5 = $62.5B decrease in GDP. Net effect = $100B - $62.5B = $37.5B. Choice B incorrectly adds both effects as positive. Choice C uses only the net trade change ($15B) without applying the multiplier. Choice D shows the calculation components but not the final net result.
- In an economy where the marginal propensity to consume is 0.9, an initial increase in autonomous investment of $20 billion will lead to a total increase in which of the following?
Answer: Consumption of $180 billion and saving of $20 billion.
First, calculate the spending multiplier: 1/(1−0.9)=10. The total change in GDP (Y) is 10×$20B=$200B. The total change in consumption (C) is ΔC=MPC×ΔY=0.9×$200B=$180B. The total change in saving (S) is ΔS=MPS×ΔY=(1−0.9)×$200B=0.1×$200B=$20B. In equilibrium, the total change in leakages (saving) must equal the initial injection (investment), so ΔS=ΔI. The change in investment was $20 billion, so the total change in saving must also be $20 billion. - An economy has a marginal propensity to consume of 0.8 and currently operates $200 billion below its full-employment level of GDP. If the government wants to close this recessionary gap using only tax policy, by how much should taxes be changed?
Answer: Taxes should be decreased by $50 billion to generate the needed stimulus
When you encounter a recessionary gap problem involving tax policy, you need to understand how tax changes create multiplied effects through the economy. The key is recognizing that tax cuts work indirectly—they increase disposable income, which then increases consumption spending.
To close the $200 billion recessionary gap, start by calculating the spending multiplier: Multiplier=1−MPC1=1−0.81=5
However, tax changes work through the tax multiplier, which is always one less than the spending multiplier: Tax Multiplier=−(MPC×Spending Multiplier)=−(0.8×5)=−4
The negative sign indicates that tax cuts (negative tax changes) produce positive GDP effects. To find the required tax change: Tax Change=Tax MultiplierDesired GDP Change=−4200=−50
This means taxes should be decreased by $50 billion.
Choice A is wrong because increasing taxes would worsen the recession, not close the gap. Choice B incorrectly uses the spending multiplier ($200 ÷ 0.8 = $250) instead of accounting for the indirect effect of tax policy. Choice D uses an incorrect multiplier calculation, possibly confusing the tax multiplier magnitude with the spending multiplier.
Remember: tax multipliers are always smaller in absolute value than spending multipliers because taxes work indirectly through consumption changes, while government spending directly impacts aggregate demand. Always calculate both multipliers separately in fiscal policy problems. - An increase in government spending causes a larger increase in equilibrium real GDP in the Keynesian cross model than in the aggregate demand-aggregate supply (AD-AS) model. This is because the Keynesian cross model assumes which of the following?
Answer: A constant price level.
The simple Keynesian multiplier (from the Keynesian cross model) assumes that the price level is fixed. In the AD-AS model, an increase in aggregate demand along an upward-sloping short-run aggregate supply curve leads to a higher price level. This price level increase mitigates the increase in real GDP through the wealth and interest-rate effects. Therefore, the fixed-price assumption of the Keynesian cross model leads to a larger predicted impact on real GDP.
- If the money multiplier in an economy is 4 and the spending multiplier is 5, what would be the total effect on GDP of a $10 billion open market purchase by the central bank, assuming the entire increase in money supply leads to increased investment spending?
Answer: GDP increases by $200 billion through the combined monetary and fiscal transmission mechanisms
When you encounter questions about monetary policy transmission, you need to trace how central bank actions flow through multiple economic channels to affect GDP.
An open market purchase of $10 billion increases bank reserves by $10 billion. With a money multiplier of 4, the total money supply increases by 10×4=40 billion. Since we're told this entire $40 billion increase translates into investment spending, we then apply the spending multiplier of 5 to find the total GDP effect: 40×5=200 billion.
The key insight is that these multipliers work sequentially, not separately. The money multiplier determines how much new spending is generated, then the spending multiplier determines the final GDP impact.
Answer A misses the monetary transmission entirely, applying only the spending multiplier to the original 10billionpurchase(10×5=50$). Answer C stops after the money multiplier effect, calculating only the increase in money supply (40billion)withoutconsideringhowthatnewspendingripplesthroughtheeconomy.AnswerDincorrectlyaddstheeffects(40+50=90$), treating the multipliers as independent rather than sequential processes.
Remember that monetary policy works through a chain reaction: central bank action → money supply change → spending change → multiplied GDP effect. Always trace through each step systematically, and watch for questions that try to confuse you about whether multipliers work together or separately. - If the marginal propensity to save is 0.2, and the government pursues a $50 billion expansionary fiscal policy, the difference in the impact on real GDP between a pure increase in government spending versus a pure decrease in lump-sum taxes would be
Answer: $50 billion
First, find the multipliers. If MPS=0.2, then MPC=0.8. The spending multiplier is 1/MPS=1/0.2=5. The tax multiplier is −MPC/MPS=−0.8/0.2=−4. The impact of a $50 billion spending increase is 5×$50B=+$250B. The impact of a $50 billion tax cut is −4×−$50B=+$200B. The difference between these two impacts is $250B−$200B=$50B. - Consider an open economy with the following characteristics: the marginal propensity to consume is 0.8, the proportional income tax rate is 25%, and the marginal propensity to import is 0.1. What is the value of the government spending multiplier?
Answer: 2.0
The multiplier in an open economy with proportional taxes is calculated as 1/(1−slope of AE). The slope of the aggregate expenditure (AE) curve is given by MPC(1−t)−MPM, where 't' is the tax rate and MPM is the marginal propensity to import. First, calculate the slope: 0.8(1−0.25)−0.1=0.8(0.75)−0.1=0.6−0.1=0.5. The multiplier is then 1/(1−0.5)=1/0.5=2.0. - In an economy with a marginal propensity to consume of 0.75, the government implements a $100 billion increase in government spending while simultaneously increasing taxes by $150 billion. What is the net effect on equilibrium GDP?
Answer: GDP decreases by $50 billion
When you encounter questions about simultaneous fiscal policy changes, you need to analyze each policy's effect separately using the appropriate multipliers, then combine them.
The government spending multiplier is 1−MPC1=1−0.751=4. So the $100 billion spending increase will boost GDP by 100×4=400 billion.
The tax multiplier is 1−MPC−MPC=1−0.75−0.75=−3. The $150 billion tax increase will reduce GDP by 150×3=450 billion (the negative sign means GDP falls when taxes rise).
The net effect combines both impacts: 400−450=−50 billion, meaning GDP decreases by $50 billion.
Answer A ($200 billion decrease) incorrectly adds the absolute values of both effects without considering that government spending has a positive impact. Answer B ($50 billion increase) gets the magnitude right but the wrong direction—this would be correct if taxes had decreased instead of increased. Answer C ($250 billion increase) appears to subtract the tax change from the spending effect incorrectly, perhaps using 400−150=250, which ignores the multiplier effect on taxes entirely.
Remember that the government spending multiplier is always larger in absolute value than the tax multiplier because government spending directly enters GDP, while tax changes work indirectly through consumption. This is why even "balanced budget" changes (equal spending and tax increases) still affect GDP—the spending effect dominates. - Following a $10 billion increase in autonomous government spending in an economy with an MPC of 0.9, what is the increase in aggregate expenditure in the third round of spending?
Answer: $8.1 billion
The multiplier effect unfolds in rounds. Round 1 is the initial injection of spending, which is $10 billion. This becomes income for the recipients. In Round 2, they spend a fraction (the MPC) of this new income: 0.9×$10 billion=$9 billion. This $9 billion becomes income for the next group. In Round 3, this group spends a fraction (the MPC) of their new income: 0.9×$9 billion=$8.1 billion. - In an economy with a marginal propensity to consume of 0.8, which of the following fiscal policy actions would have the largest effect on aggregate demand?
Answer: A $100 billion increase in government spending.
We need to compare the change in GDP (ΔY) from each policy. The spending multiplier is 1/(1−0.8)=5. The tax multiplier is −0.8/0.2=−4. The balanced budget multiplier is 1. A) ΔY=5×$100B=+$500B. B) ΔY=−4×−$100B=+$400B. C) ΔY=1×$100B=+$100B. D) ΔY=−4×−$120B=+$480B. Comparing the results, the $100 billion increase in government spending has the largest effect on aggregate demand. - Assume an economy has a marginal propensity to consume of 0.8. The government increases its purchases by $200 billion. This action raises interest rates, which causes autonomous investment to decrease by $50 billion. What is the net change in real GDP?
Answer: $750 billion
This question incorporates the crowding-out effect. First, calculate the spending multiplier: 1/(1−MPC)=1/(1−0.8)=5. The initial change in government spending (ΔG) is +$200 billion, but this is partially offset by the decrease in investment (ΔI) of -$50 billion. The net initial change in autonomous spending is ΔG+ΔI=$200−$50=$150 billion. The total change in GDP is this net change times the multiplier: 5×$150 billion=$750 billion. - In a closed economy with no government, autonomous consumption is $100 billion, the marginal propensity to consume is 0.6, and planned investment is $80 billion. If investment increases to $120 billion, what is the new equilibrium level of GDP?
Answer: The new equilibrium GDP will be $550 billion after the multiplier effect
This question tests your understanding of the expenditure multiplier in a simple Keynesian model. When you see autonomous spending changes in a closed economy, you need to calculate both the direct effect and the multiplied indirect effects.
Start by finding the multiplier: k=1−MPC1=1−0.61=0.41=2.5
The change in investment is $120 billion - $80 billion = $40 billion. Using the multiplier effect, the change in equilibrium GDP will be: ΔGDP=k×ΔI=2.5×40=100 billion
To find the new equilibrium GDP, you need the original equilibrium. In equilibrium, GDP equals total spending: GDP=C+I=100+0.6(GDP)+80. Solving: GDP−0.6(GDP)=180, so 0.4(GDP)=180, giving us $450 billion originally.
The new equilibrium GDP is $450 billion + $100 billion = $550 billion.
Answer A ($450 billion) gives you the original equilibrium GDP before the investment increase. Answer C ($500 billion) incorrectly applies a multiplier of 2 instead of 2.5, a common error when students confuse the multiplier formula. Answer D ($320 billion) appears to calculate autonomous spending ($100 + $80 + $140 = $320) but misses the entire multiplier concept.
Remember: in multiplier questions, always identify the multiplier first, then calculate the total change in GDP, not just the change in autonomous spending. The multiplier amplifies the initial spending change throughout the economy. - The value of the simple spending multiplier will decrease if which of the following occurs?
Answer: Households decide to save a larger fraction of each additional dollar of income.
The simple spending multiplier is given by the formula 1/(1−MPC) or 1/MPS. The multiplier's value is inversely related to the marginal propensity to save (MPS) and directly related to the marginal propensity to consume (MPC). If households decide to save a larger fraction of each additional dollar of income, the MPS increases. An increase in the MPS (the denominator in 1/MPS) will cause the value of the multiplier to decrease. - In a closed economy, the marginal propensity to consume is 0.75. If both autonomous investment and lump-sum taxes increase by $50 billion, what is the resulting change in the equilibrium level of real GDP?
Answer: An increase of $50 billion
We need to calculate the impact of each change separately and then sum them. With MPC = 0.75, the spending multiplier is 1/(1−0.75)=4, and the tax multiplier is −0.75/(1−0.75)=−3. The increase in investment of $50 billion will increase GDP by 4×$50 billion=+$200 billion. The increase in taxes of $50 billion will decrease GDP by −3×$50 billion=−$150 billion. The net effect is the sum of these two changes: +$200 billion−$150 billion=+$50 billion. - In a closed economy with no government taxes, the consumption function is given by the equation C=200+0.75Yd, where Yd is disposable income. If autonomous investment falls by $30 billion, what is the resulting total change in equilibrium consumption?
Answer: A decrease of $90 billion
The marginal propensity to consume (MPC) is 0.75. The expenditure multiplier is 1/(1−MPC)=1/(1−0.75)=4. The total change in real GDP (Y) is the multiplier times the initial change in investment: 4×(−$30 billion)=−$120 billion. The question asks for the total change in consumption, not GDP. The total change in consumption is induced by the change in income, so ΔC=MPC×ΔY=0.75×(−$120 billion)=−$90 billion. - If the marginal propensity to save increases from 0.2 to 0.3 while autonomous consumption remains constant, how does this change affect the expenditure multiplier and the impact of a $50 billion increase in investment spending on equilibrium GDP?
Answer: The multiplier decreases from 5 to 3.33, reducing the GDP impact from $250 billion to $167 billion
When you encounter questions about the marginal propensity to save (MPS) and multipliers, remember that these concepts are inversely related through the expenditure multiplier formula.
The expenditure multiplier equals MPS1. When MPS increases from 0.2 to 0.3, the multiplier changes from 0.21=5 to 0.31=3.33. This decrease makes economic sense: when people save more of each additional dollar earned, less money circulates through the economy, reducing the multiplier effect.
With a $50 billion investment increase, the GDP impact equals the multiplier times the spending change. Initially: 5×$50 billion=$250 billion. After the MPS increase: 3.33×$50 billion=$167 billion.
Answer A incorrectly calculates the multiplier as 1−MPS1 but uses the wrong MPS values, getting 1.25 and 1.43 instead of the correct 5 and 3.33. Answer B shows the opposite relationship, suggesting the multiplier increases when MPS rises, which contradicts the inverse relationship. Answer D claims the multiplier stays constant at 2.5, ignoring that MPS changes directly affect the multiplier calculation.
The key study tip: memorize that multiplier = MPS1 and remember the inverse relationship. Higher savings rates mean lower multipliers because less money recirculates. Also, note that some textbooks use MPC1 where MPC = 1 - MPS, but both formulas yield the same result.
