If the expenditure multiplier is estimated to be 1.5, then if the government expands its spending by $100 billion, we expect GDP to rise by
Answer: (c) $150 billion.
The answer is Option (c)
A very simple question.
In this blog post - Spending Multipliers (December 28, 2009) - I provided a detailed analysis of what determines the value of the expenditure multiplier.
The expenditure multiplier, which describes the GDP adjustment mechanism that occurs when an existing equilibrium is disturbed by a new spending injection (or withdrawal), is an essential part of the policy making tool kit because it answers the question as to how large an initial stimulus or contractionary package have to be to achieve the desired final outcomes.
GDP and national income will rise if planned spending rises and will fall if planned spending falls.
The question of interest now is by how much will GDP and national income change after a change in planned spending driven, for example, by a change in government spending.
The expenditure multiplier describes a multi-period adjustment process following an initial change in spending.
From an initial equilibrium position, an increase in spending expenditure (say by government) provides an instant boost to total spending.
Firms respond to the increased planned expenditure and raise employment to produce the increased output or GDP. National income increases.
This rise in national income induces further consumption spending which leads to a further rise in aggregate spending, employment and GDP. A proportion of the rise in national income leaks out in the form of higher tax payments, import spending and increased saving.
So, after each 'round', the induced spending boost gets smaller and smaller.
The process continues until the induced spending becomes so small that there are no further GDP increases. On the other hand, a fall in autonomous expenditure leads to a series of cuts in employment, GDP and tax payments, imports and saving.
The expenditure multiplier thus indicates by how much GDP and national income changes when there is a change in autonomous expenditure. The larger is the multiplier, the larger is the change in GDP and national income for a given change in autonomous expenditure.
So, if the multiplier was 1.8, for example, then if the government increased its spending by $1, total GDP would rise by $1.80. If the multiplier was below
1, then a $1 increase in government spending, for example, would lead to less than $1 rise in GDP, which means a fiscal stimulus would fail.
So in this case, the initial exogenous injection of $100 billion by the government would lead to an overall increase in GDP of $150 billion.
So the answer is Option (c).