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

Question

2. The multiplier effect of a change in government purchases Consider a 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 purchases will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on. Fill in the following table to show the Impact of the change in government purchases on the first two rounds of consumption spending and, eventually, on aggregate demand. Change in Government Purchases = -$250 billion First Change in Consumption = Second Change in Consumption = Total Change in Demand = The following graph shows the aggregate demand curve (AD1) for this economy before the change in government spending. Use the green line (triangle symbols) to plot the new aggregate demand curve (AD2) after the multiplier effect takes place. For simplicity, assume that there is no ''crowding out.'' Be sure that the new aggregate demand curve (AD2) is parallel to the initial aggregate demand curve (AD1). You can see the slope of AD1 by mousing over it on the graph.

Explanation / Answer

Multiplier= 1/(1-MPC)

The MPC is 0.75, the multiplier is 4 1/(1-.75)

The first consumption change is=0.75 x -250= $187.5

the second consumtion change= 187.5 x 0.75= $140.625

The total change in demand = (MPC x -250) + (MPC2 x -250)+.......

= (250x 1)/(1-MPC)

=4 x -250

The total change in demand = -1000

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