Real GDP Increase: Let's Calculate the Impact of Government Spending!

What happens to real GDP when the government increases its purchases of goods and services?

If the marginal propensity to save is 0.25, investment spending is $700 million, and the government increases its purchases of goods and services by $100 million, then what will be the impact on real GDP?

Real GDP will increase by $400 million.

The increase in government purchases of goods and services represents an increase in government spending, contributing to aggregate demand. This increase will have a multiplier effect on the economy, leading to a larger overall increase in real GDP.

The multiplier effect is determined by the marginal propensity to save (MPS), which is the proportion of additional income that individuals choose to save rather than spend. In this case, the MPS is 0.25, indicating that 25% of any increase in income will be saved.

To calculate the overall increase in real GDP, we can use the formula: ΔGDP = (1 / (1 - MPS)) * ΔSpending.

Given that the increase in government purchases is $100 million and the MPS is 0.25, we can calculate as follows:

ΔGDP = (1 / (1 - 0.25)) * $100 million = (1 / 0.75) * $100 million = $133.33 million.

Therefore, real GDP will increase by $400 million ($133.33 million * 3), as each dollar of increased spending generates additional income and spending throughout the economy.