Real GDP equals $200 billion, the government collects 20% of any increase in real GDP in the form of taxes, and the marginal propensity to consume is 0.8. If the government increases spending by $10 billion, real GDP will increase by:

A) $10 billion.
B) $20 billion.
C) $27.8 billion.
D) $50 billion.

If he government increases spending by $10 billion, real GDP will increase by $27.8 billion. The right answer is C.

Explanation:

In order to calculate how much the real GDP will increase, we have to calculate the Expenditure multiplier with the following formula:

Expenditure Multiplier = [1/(1-MPC(1-tax)]

Expenditure  Multiplier = [1/(1-0.8(1-0.2)]

Expenditure  Multiplier = [1/(1-0.8(0.8)]

Expenditure  Multiplier = [1/(0.36)]

Expenditure  Multiplier = 2.778

So, an increase in G by $10 billion will increase real GDP by $10 x 2.778 = $27.8 billion.

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