4. The multiplier effect of a change in government purchases Consider a hypothet

Question

4. The multiplier effect of a change in government purchases Consider a hypothetical closed economy in which households spend $0.70 of each additional dollar they earn and save the remaining $0.30 The marginal propensity to consume (MPC) for this economy is , and the spending multiplier for this economy is Suppose the government in this economy decides to decrease government purchases by $300 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to second change in consumption equal to This decreases income yet again, causing a The total change in demand resulting from the initial change in government spending The following graph shows the aggregate demand curve (AD) for this economy before the change in government spending Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2) after the multiplier effect takes place. For simplicity, assume tha there is no "crowding out." Hint: Be sure that the new aggregate demand curve (AD2) is parallel to the initial aggregate demand curve (AD). You can see the slope of AD by selecting it on the graph 140 135 AD 130 125 120 0 115 110 105 100 OUTPUT (Trillions of dollars)

Explanation / Answer

The marginal propensity to consume for this economy is $0.70, that is the additional unit spend on consumption, while the spending multiplier is given by 1/MPS = 1/$0.30 = 3.33

The decrease in government spending by $300 billion will cause an initial change in consumption equal to $0.70 * $300 billion = $ 210 billion.

Second change in consumption is equal to $0.70 * $210 billion = $147 billion.

The total change in demand is $300 billion * multiplier = $ 300 billion * 3.33 = $999 billion

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