An economy is facing deficient demand. The marginal propensity to consume is 0.75 and taxes are lump-sum. By how much must the government raise its purchases of goods and services to raise equilibrium income by 400?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → 100
Given:
MPC, c = 0.75 (lump-sum taxes)
Required rise in income, ΔY = 400
ΔY = government expenditure multiplier × ΔG, and the multiplier is 1 ÷ (1 − c).
Multiplier = 1 ÷ (1 − 0.75) = 1 ÷ 0.25 = 4
ΔG = 400 ÷ 4 = 100
Option (1) 300 — this uses the MPC in place of the multiplier.
Option (2) 1600 — this multiplies 400 by the multiplier (1,600) instead of dividing.
This question uses Determination of Income and Employment (deficient demand) and Government Budget and the Economy (the expenditure multiplier) together.
NCERT (2026-27): Determination of Income and Employment: “4.4 Some More Concepts … If it is less than the full employment of output, it is due to the fact that demand is not enough to employ all factors of production. This situation is called the situation of deficient demand. …” Government Budget and the Economy: “Changes in Government Expenditure We consider the effects of increasing government purchases (G) keeping taxes constant. When G exceeds T, the government runs a deficit. Because G is a component of aggregate spending, planned aggregate expenditure will increase. The aggregate demand schedule shifts up to AD′. At the initial level of output, demand exceeds supply and firms expand production. The new equilibrium is at E′. The multiplier mechanism (described in Chapter 4) is in operation. …” Glossary: “Government expenditure multiplier – The numerical coefficient showing the size of the increase in output resulting from each unit increase in government spending.” |