If the government wishes to increase the equilibrium level by R100 million, it should:
A. Increase government spending by R100 million.
B. Increase government spending by less than R100 million.
C. Increase government spending by more than R100 million.
D. Increase the tax rate.
E. decrease government spending by R100 million divided by the multiplier.
The correct answer and explanation is:
The correct answer is B. Increase government spending by less than R100 million.
To understand why this is the correct response, it’s important to consider the concept of the multiplier effect. In economics, the multiplier effect refers to the process by which an increase in government spending leads to a larger overall increase in the economy’s total output or income. The size of the multiplier depends on factors like the marginal propensity to consume (MPC), which is the fraction of additional income that households spend on consumption.
When the government increases its spending, it directly increases the demand for goods and services. This increase in demand can lead to higher income for households and businesses, which in turn leads to further spending, creating a cycle. However, this initial increase in spending will be amplified, meaning that the total increase in income or equilibrium level will be greater than the initial spending increase.
For example, if the multiplier is 2, a government spending increase of R50 million would lead to an overall increase in the equilibrium level of R100 million. The equation for the multiplier effect can be written as: Total Increase in Output=Initial Government Spending×Multiplier\text{Total Increase in Output} = \text{Initial Government Spending} \times \text{Multiplier}
Therefore, to achieve an increase in equilibrium of R100 million, the government would need to increase spending by less than R100 million because the spending multiplier amplifies the effect.
In summary, the government should increase its spending by less than R100 million, and the exact amount depends on the value of the spending multiplier, which varies based on factors like consumption habits and saving behavior in the economy.