Question

Explain why a \(500 million increase in government purchases of goods and services will generate a larger rise in real GDP than a \)500 million increase in government transfers.

Short answer

A $500 million increase in government purchases has a multiplier effect, leading to a greater increase in income, whereas a government transfer stabilizes the aggregate demand and GDP.

Step-by-step solution

Explanation 

Government purchase is one of the components of aggregate demand that determines the equilibrium level of GDP. A $500 million increase in government expenditure will indirectly affect the other components as well and thus will result in a greater increase in the GDP level than $500 million. For example, an increase in government purchases increases the demand for goods and services, increasing the investment and production of output, leading to greater employment opportunities and higher income and consumption expenditure.

The real GDP will increase by:$\$500million\times \left(\frac{1}{1-MPC}\right)$.

A government transfer is a stabilizer that ensures that the minimum level of consumption is maintained and the GDP level remains stable. It depends on the mpc.

Suppose, MPC = 0.8, then the increase in real GDP due to government purchases will be $2500 million$\left(500\times \frac{1}{1-0.8}=500\times 5=\$2500million\right)$; the increase in real GDP due to government transfer will be $400 million $\left(500\times 0.8=\$400million\right)$.

Thus, a $500 million government purchase results in a greater change in GDP than government transfer.