Question

Applying Economic Concepts Suppose that the federal government decides to increase its spending on highway construction by \(\$ 5\) billion to keep the economy from falling into a recession. Explain the real impact on GDP of this spending.

Short answer

The \( \$ 5 \) billion spending could lead to a \( \$ 25 \) billion increase in GDP due to the multiplier effect.

Step-by-step solution

Understand the Context

The Federal government is increasing spending to prevent a recession, targeting the highway construction sector with an additional \( \$ 5 \) billion.

Define the Economic Concept

The problem involves understanding the concept of the multiplier effect in macroeconomics, which suggests that an initial increase in spending will lead to a more than proportional increase in the overall GDP.

Determine the Multiplier Effect

The multiplier effect is calculated by the formula: \[ \text{Multiplier} = \frac{1}{1 - MPC} \]where MPC is the marginal propensity to consume. This tells us how much GDP is likely to increase based on increased government spending.

Calculate the Impact

Assuming a typical MPC value (like 0.8), calculate the multiplier: \[ \text{Multiplier} = \frac{1}{1 - 0.8} = 5 \]This means the \( \\( 5 \) billion spending could potentially increase GDP by: \[ \\) 5 \, \text{billion} \times 5 = \$ 25 \, \text{billion} \]

Evaluate the Conclusion

Based on the calculated multiplier and assumed MPC, the initial government spending of \( \\( 5 \) billion could increase GDP by \( \\) 25 \) billion, indicating a substantial economic impact preventing the recession.

Key concepts

GDP impact

The Gross Domestic Product (GDP) is a crucial measure that indicates the economic performance of a nation. When the government injects money into the economy, such as increasing spending on infrastructure like highway construction, it directly influences GDP.
The initial sum spent by the government enters the economic system through various channels – such as wages for construction workers and payments to material suppliers. These entities then spend this income, circulating it further through the economy.
This chain reaction leads to a broader effect known as the multiplier effect, which amplifies the initial government spending to result in a larger impact on GDP than the original expenditure. If the government spends \(5\) billion dollars, and if the multiplier is 5, the GDP could potentially increase by \(25\) billion dollars. This results in a significant economic stimulus, assisting in countering recessionary pressures.

marginal propensity to consume

The marginal propensity to consume (MPC) is an economic concept that reflects the proportion of additional income that a household will spend rather than save. Imagine you receive an unexpected income boost; how much of it do you spend right away?
In a broader economic context, MPC helps to understand how spending can influence economic growth. An MPC of 0.8, for instance, indicates that for every additional dollar earned, a household will spend 80 cents and save 20 cents.
This concept is essential for calculating the multiplier, using the formula \[ \text{Multiplier} = \frac{1}{1 - MPC}. \]Understanding MPC allows economists to forecast the ripple effect of increased spending within the economy, predicting how initial government investments can expand through consumption across different sectors.

government spending on infrastructure

Government spending on infrastructure, such as highways, is pivotal for economic development. This type of spending does more than just improve roads; it generates jobs, enhances travel efficiency, and strengthens the overall economy.
When the government allocates funds to infrastructure, it provides immediate benefits such as employment for construction workers and demand for building materials. Over time, the improved infrastructure supports economic activities by reducing transportation costs and promoting trade.
The impact extends beyond immediate economic benefits, laying the groundwork for sustainable economic expansion. Effective infrastructure projects can attract more investments and stimulate productivity, driving long-term growth. Therefore, strategic government spending on infrastructure acts as a catalyst for enhancing national economic resilience.