Question

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 expenditure 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 _____. This decreases income yet again, causing a second change in consumption equal to ______. The total change in demand resulting from the initial change in government spending is _____ .

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

MPC = 0.7

Expenditure multiplier = 1/1-MPC = 1/1-0.7=3.3

Change in consumption = 0.7 *$300= $210

Change in another consumption= 0.7*$210=$147

Total demand change = -$300* 3.33 =$999

The New AD curve will shift left ward parallel to the initial curve.