Questions: Aggregate Demand: The Expenditure Approach

Question 1

The marginal propensity to consume (MPC) is 0.75. The government increases spending by $200 billion. In the simple Keynesian model, what is the total change in GDP?

• A. $200 billion — government spending adds directly to GDP, dollar for dollar
• B. $150 billion — only the fraction b = 0.75 of the spending circulates
• C. $800 billion — the multiplier is 1/(1 − 0.75) = 4
• D. $600 billion — the multiplier applies only to the induced rounds, not the initial injection

Answer: (C)

The Keynesian multiplier is 1/(1 − MPC) = 1/(1 − 0.75) = 4. So $200bn × 4 = $800bn. The initial $200bn enters income directly; recipients spend $150bn (75%), those recipients spend $112.5bn, and so on — a geometric series that sums to $200bn × 4. Option D is a common error: the formula 1/(1−MPC) already includes the initial injection in the total.

Question 2

Which factor most directly explains why real-world fiscal multipliers are consistently smaller than the simple formula 1/(1−MPC) predicts?

• A. People don't actually spend exactly the MPC fraction of each income round
• B. Government cannot accurately measure the MPC in real time
• C. Crowding out, import leakage, and monetary policy tightening absorb part of the stimulus
• D. The multiplier formula only applies to tax cuts, not government spending

Answer: (C)

The textbook multiplier 1/(1−MPC) assumes no leakages and no offsetting policy responses. In reality: (1) crowding out — government borrowing raises interest rates, reducing private investment; (2) import leakage — some income is spent on foreign goods rather than domestic output; (3) monetary policy — central banks may raise rates to prevent inflation, contracting interest-sensitive spending. All three attenuate the multiplier below its theoretical value.

Question 3

A $100 billion direct government purchase of goods has a larger first-round multiplier impact than a $100 billion tax cut of the same size.

• T. True
• F. False

Answer: True

Direct government purchases inject the full $100bn into GDP immediately — the multiplier is 1/(1−MPC). Tax cuts first pass through households: recipients save fraction (1−MPC) before spending the rest, so only MPC × $100bn enters the spending stream in the first round. The tax cut multiplier is MPC/(1−MPC). With MPC = 0.8, government purchases have a multiplier of 5 vs. 4 for an equivalent tax cut.

Question 4

In the simple Keynesian model, increasing government spending typically raises GDP by more than the initial increase, regardless of the state of the economy.

• T. True
• F. False

Answer: False

The multiplier greater than 1 assumes spare capacity exists so output can actually increase. Near full employment, supply is constrained: extra demand raises prices rather than real output, attenuating the real GDP effect. Crowding out can reduce private investment, partially or fully offsetting the stimulus. With an active monetary policy (central bank raising rates in response), the effective multiplier can fall below 1 or even to zero. The simple model ignores these constraints.

Question 5

Explain in your own words why a rise in government spending increases GDP by more than the initial injection — and what limits this amplification in practice.

Model answer: The initial spending becomes income for its recipients, who spend a fraction (MPC) of it, which becomes income for others, who spend MPC of that, and so on — a self-reinforcing chain that sums to 1/(1−MPC) times the original injection. In practice, leakages break the chain: households save part of each income round, some spending flows to imports rather than domestic output, government borrowing may crowd out private investment, and monetary tightening can offset the stimulus.

The circular flow logic is key: spending = income = spending. The multiplier captures the total amplification. The leakages — saving, imports, crowding out, monetary response — are the forces that bring the real-world multiplier well below its theoretical value, often below 1 in full-employment or open economies.