An economy has a fixed price level, no imports, and no income taxes. MPC is 0.8 , and real GDP is $150 billion. Businesses increase investment by $2 billion. Calculate the new level of real GDP and explain why real GDP increases by more than $2 billion.

a) $10 billion

b) For example, the investment made by the business in this question would become income in the hands of other transacting economic agents which in turn be re-spent by them.

Explanation:

Expenditure Multiplier is the amount by which the real GDP will change if autonomous expenditure changes by a given amount.

It is calculated as follows: 1 / (1-MPC).

MPC is the portion of additional income that is spent. If the MPC is 0.8, then the expenditure multiplier will be = 1 / (1-0.8) = 5

Using the information given, if business investment increase by $2 billion, the resulting change in GDP would be

increase in real GDP = 2 billion * 5 = $10 billion

Explanation of the multiplier change in real GDP

Real GDP increases by more than 2 billion because of the multiplier effect. This effect is implies that expenditures by made by one economic agent in a transaction becomes income in the hand of another which in turn be re-spent. This will continue in manifolds thereby increasing the total value of goods and services resulting from a single increase in autonomous spending in multiple fold.

For example, the investment made by the business in this question would become income in the hands of other transacting economic agents.