Question

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

Short answer

A reduction in government purchases is more effective at reducing the real GDP than a reduction in government transfers because the multiplier is active on government purchases and not on government transfers.

Step-by-step solution

Explanation

A $500 million decrease in government purchases will reduce the real GDP by $500 million multiplied by the multiplier, where the multiplier is $\frac{1}{1-MPC}$.

A $500 million reduction in government transfers will only reduce the consumption by the amount of MPC multiplied by the $500 million.

This can be explained using an example:

Suppose the MPC is 0.5, the reduction in real GDP if the government purchase reduces by $500 million is $1000 million $\left(500\times \frac{1}{1-0.5}=500\times 2=\$1000million\right)$and the reduction in real GDP if the government transfer reduces by $500 million is $250 million $\left(500\times 0.5=\$250million\right)$.

Hence, the reduction in real GDP will be greater when there is a reduction in government purchases rather than government transfers.