Background: Between 2002 and 2003, the United States government increased its purchases on military goods and services by $10 billion for the war in Afghanistan. Economic theory suggests that this increase in government purchases would trigger a "multiplier effect,"causing an increase in real GDP that is greater than the $10 billion increase in government purchases. For simplicity, let's assume that there were no other spending changes in the economy. Suppose that the marginal propensity to consume in the United States is approximately 0.4, and real GDP in 2002 was $10 trillion, or $10,000 billion. When government purchases increased by $10 billion from 2002 to 2003, companies that manufactured military goods received an additional $10 billion in sales revenue, which ultimately became factor payments (income) to those who provided resources to those companies. These included the employees (who received wages and salaries), the shareholders (who received profits), those who supplied land (who received rent), and those who provided loans for capital equipment (who received interest). When the income of these resource providers rose, consumption spending increased. This increase in consumption spending created more sales revenue for other firms — consumers spent more buying food, clothing, and other goods and services. This triggered another round of increases in sales revenue for companies, which, again, became increased income for their employees and other resource providers. In the end, after the entire chain reaction takes place, real GDP would have increased by
Background: Between 2002 and 2003, the United States government increased its purchases on military goods and services by $10 billion for the war in Afghanistan. Economic theory suggests that this increase in government purchases would trigger a "multiplier effect,"causing an increase in real GDP that is greater than the $10 billion increase in government purchases. For simplicity, let's assume that there were no other spending changes in the economy. Suppose that the marginal propensity to consume in the United States is approximately 0.4, and real GDP in 2002 was $10 trillion, or $10,000 billion.
When government purchases increased by $10 billion from 2002 to 2003, companies that manufactured military goods received an additional $10 billion in sales revenue, which ultimately became factor payments (income) to those who provided resources to those companies. These included the employees (who received wages and salaries), the shareholders (who received profits), those who supplied land (who received rent), and those who provided loans for capital equipment (who received interest). When the income of these resource providers rose, consumption spending increased. This increase in consumption spending created more sales revenue for other firms — consumers spent more buying food, clothing, and other goods and services. This triggered another round of increases in sales revenue for companies, which, again, became increased income for their employees and other resource providers. In the end, after the entire chain reaction takes place, real GDP would have increased by
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