2. 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.
This is the same issue as in Problem 1, but in reverse. If government purchases of goods and services fall by $500 million, the initial fall in aggregate spending is $500 million. If there is a $500 million reduction in government transfers, the initial fall in aggregate spending is MPC × $500 million, which is less than $500 million.