Question

Suppose there is some hypothetical closed economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25.

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 $250 billion. The decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to $______ billion. This decreases income yet again, leading to a second change in consumption equal to $________ billion . The total change in demand resulting from the initial change in government spending is $ ________ trillion.


The following graph shows the aggregate demand curve (AD1AD1) for this economy before the change in government spending.


Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."


Hint: Be sure that the new aggregate demand curve (AD2AD2) is parallel to the initial aggregate demand curve (AD1AD1). You can see the slope of AD1AD1 by selecting it on the graph.

Answer 1

1. MPC = 0.75, Spending multiplier = 4.

2. A decrease in government purchases by $250 billion leads to an initial change in consumption of $187.5 billion and a second change of $140.625 billion. The total change in demand is $528.125 billion.

3. The new aggregate demand curve (AD2) is parallel to the initial curve (AD1) and is plotted using the green line (triangle symbol).

Step-by-step explanation:

In this hypothetical closed economy, households exhibit a marginal propensity to consume (MPC) of 0.75, meaning they spend 75% of any additional income and save the remaining 25%. The spending multiplier, which is the reciprocal of the marginal propensity to save (MPS), is calculated as 1/MPS, resulting in a multiplier of 4.

When the government decides to decrease purchases by $250 billion, the initial change in consumption is determined by multiplying the change in government spending by the MPC. This yields an initial consumption change of $187.5 billion. Subsequently, this reduction in consumer spending leads to a further decrease in income, triggering a second round of consumption change. The resulting change in consumption is $140.625 billion. The total change in demand is the sum of the initial and subsequent changes, amounting to $328.125 billion or $0.3281 trillion.

This exemplifies the multiplier effect, illustrating how an initial change in government spending sets off a chain reaction, influencing aggregate demand and income multiple times over. To visually represent this economic phenomenon on the aggregate demand curve (AD1), a parallel shift is made to plot the new curve (AD2) after the multiplier effect. The green line (triangle symbol) signifies this new aggregate demand curve, assuming no "crowding out" effects.

Answer 2

The marginal propensity to consume (MPC) for this economy is 0.75 , and the spending multiplier for this economy is 4.

The initial change in consumption equal to $187.5 billion

The total change in demand resulting from the initial change in government spending is $1 trillion.

How is that so?

1. Marginal Propensity to Consume (MPC) and Spending Multiplier:

MPC: MPC is the fraction of additional income that consumers spend. In this case, households spend $0.75 of each additional dollar they earn. Therefore, MPC = 0.75.

Spending Multiplier: The spending multiplier is the total change in income resulting from a change in government spending. It's calculated as 1 / (1 - MPC). In this case, the spending multiplier = 1 / (1 - 0.75) = 4.

2. Initial Change in Consumption:

The decrease in government spending of $250 billion represents the initial change in aggregate demand.

Since MPC is 0.75, the initial change in consumption will be:

$250 billion * 0.75 = $187.5 billion

3. Subsequent Changes in Consumption:

The primary decrease in consumption of $187.5 billion will bring about further decreases in earnings for businesses and households.

This decrease in profit will then bring about another decrease in devouring, and so on.

This process of decrease in profit leading to further decrease in devouring is named the "multiplier effect."

4. Calculating the Total Change in Demand:

To reckon the total change in demand, we need in the end the initial change in consumption and so forth subsequent changes.

The total change standard can be calculated utilizing the following formula:

Total change standard = Initial change in spending * Giving multiplier

In this case, the total change standard will be:

$250 billion * 4 = $1 trillion

5. Plotting the New Aggregate Demand Curve:

The new aggregate demand curve (AD2) will be parallel to the initial aggregate demand curve (AD1) because the change in government spending is assumed to not affect prices (no "crowding out").

The horizontal shift in AD2 will be equal to the total change in demand, which is $1 trillion.

The slope of AD2 will remain the same as the slope of AD1, which reflects the MPC of the economy.