Assume the marginal propensity to consume (MPC) is 0.75. The government decides to increase its expenditure by Rs. 1000 crore while keeping taxes unchanged. What will be the expected increase in aggregate demand using the fiscal multiplier?
Answer
Rs. 4000 crore
The correct answer is Rs. 4000 crore — State the increase in aggregate demand as Rs. 4000 crore.
Step-by-step solution
- Recall the fiscal multiplier formula for expenditure: Multiplier = 1 / (1 – MPC).
- Plug in MPC = 0.75: Multiplier = 1 / (1 – 0.75) = 1 / 0.25 = 4.
- Calculate the change in aggregate demand: ΔAD = Multiplier × ΔG.
- Insert ΔG = Rs. 1000 crore: ΔAD = 4 × Rs. 1000 crore = Rs. 4000 crore.
- State the increase in aggregate demand as Rs. 4000 crore.
Common mistake: Using 1/MPC instead of 1/(1‑MPC) or forgetting to multiply by the change in G.
Concept tested: Fiscal multiplier effect
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