Question

Suppose that a certain country has an MPC of 0.9 and a real GDP of $400 billion. If its investment spending decreases by $4 billion, what will be its new level of real GDP?

Answer 1

The answer of this question requires the concept of spending multiplier. The changes in any component of demand sets out an infinite number of spending cycles, that increases aggregate output more than the initial change in the aggregate demand. The actual change in aggregate output due to change in aggregate demand component is determined by spending multiplier (SM).

The change in output is equal to the spending multiplier times of initial change in the component. Mathematically

            $\small \Delta Y=SM\times \Delta (demand\ component)$ …… (1)

Here ∆ refers to change and SM is spending multiplier and is given as

            $\small SM=\frac{1}{1-MPC}$ ………… (2)

Here MPC is marginal propensity to consume, the change in consumption due to one unit change in income.

Assuming MPC=0.9;

$\small SM=\frac{1}{1-0.9}=10$

AAs investment spending decreases by $4 billion;

$\small \Delta (demand\ component)=\Delta I=-4\ billlion$

$\small \therefore \Delta Y=SM\times \Delta I=10\times \left ( -4\ billion \right )=-40\ billion$

Hence, the new level of real GDP would be

$\small \therefore Y+ \Delta Y=400\ billion-40\ billion=360\ biilion$