Question

If the multiplier is 5 and investment increases by \(\$ 3\) billion, equilibrium real GDP will increase by: a. \(\$ 2\) billion. b. \(\$3\) billion. c. \(\$8\) billion. d. \(\$15\) billion. e. None of the above.

Short answer

The equilibrium real GDP will increase by \( \$15 \text{ billion} \), so the correct answer is (d).

Step-by-step solution

Understanding the Multiplier Effect

The multiplier effect demonstrates how an initial change in spending (such as investment) can lead to a larger change in equilibrium real GDP. The formula to calculate this is: \( \text{Change in GDP} = \text{Multiplier} \times \text{Change in Investment} \).

Substituting Given Values

In this problem, the given multiplier is 5, and the initial increase in investment is \( \\(3 \text{ billion} \). We use these values in the formula: \( \text{Change in GDP} = 5 \times \\)3 \text{ billion} \).

Calculating the Change in GDP

Perform the multiplication: \( 5 \times \\(3 \text{ billion} = \\)15 \text{ billion} \). This is the increase in equilibrium real GDP.

Selecting the Correct Option

With the calculated increase in GDP being \( \\(15 \text{ billion} \), we compare this with the given options. The correct answer is option (d), which states \( \\)15 \text{ billion} \).

Key concepts

Equilibrium Real GDP

Equilibrium real GDP is the level of gross domestic product (GDP) at which total production equals total demand. When the economy is in equilibrium, there are no unplanned changes in inventory levels, meaning that what businesses produce exactly meets the demand from consumers, businesses, and the government.

In practical terms, this equilibrium means:

• All output gets purchased without unexpected increases or decreases in inventory.
• GDP becomes stable unless affected by external factors like policy changes or international events.

Equilibrium GDP is influenced by macroeconomic factors such as consumer confidence, government policy, export levels, and, importantly, investment spending. When investments increase, it can push the GDP to a new equilibrium level through the multiplier effect.

Investment Change

Investment change refers to fluctuations in the amount of money being put into the economy by businesses' capital spending. Investment can come in many forms such as purchasing new machinery, building factories, or infrastructure projects. Even small changes in investment can have significant impacts on the economy.

For instance:

• Increasing investment typically signals confidence in economic growth and can drive GDP upwards.
• When businesses increase investment, it often leads to more productive capacity and innovation.

In our exercise, a $3 billion increase in investment was used to demonstrate how such a change can substantially raise equilibrium real GDP. Understanding these changes is crucial for predicting economic patterns and making informed policy decisions.

Economic Formula

The economic formula connecting investment changes to GDP changes is essential for understanding the multiplier effect. The formula is:

• \[ \text{Change in GDP} = \text{Multiplier} \times \text{Change in Investment} \]

This formula shows how initial changes in spending get magnified to have a larger effect on the overall economy. It's a simple but powerful way to see why small increases in spending can lead to larger increases in GDP.

To illustrate:

• With a multiplier of 5, if an investment increases by $3 billion, the GDP change is: \[5 \times 3 = 15 \text{ billion}\]

This straightforward calculation underpins many economic models and forecasts.

Spending Multiplier

The concept of the spending multiplier is central to understanding how economies grow beyond the initial injection of spending. A spending multiplier reflects the idea that an increase in spending leads to an even larger increase in income and economic output. This happens because:

• Each dollar spent increases income for someone else, who then spends a portion of that dollar, further spreading the spending through the economy.
• The size of this multiplier effect depends on the economy's state, consumer confidence, and marginal propensities to consume and save.

In the context of our exercise, the multiplier was given as 5, showing how potent this effect can be. A $3 billion investment thus leads to a $15 billion increase in GDP. By comprehending the multiplier, one can grasp why government policies often focus on boosting spending to stimulate growth.