The following graph shows the aggregate demand curve. Consider what happens to a

Question

The following graph shows the aggregate demand curve. Consider what happens to aggregate demand when a government increases taxes. Shift the aggregate demand curve on the graph to show the impact of a tax hike. Tool tip: Click and drag the curve. The curve will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. Suppose the governments of two different economies, economy land economy K, implement a permanent tax cut of the same size. The marginal propensity to consume (MPC) in economy J is 0.75 and the MPC in economy K is 0.5. The economies are identical in all other respects. The tax cut will have a larger impact on aggregate demand in economy

Explanation / Answer

The marginal propensity to consume is diretly related to multiplier. The greater the MPC, the greater is the multiplier effect. This means the economy with higher MPC will have greater impact of tax cut

multiplier=1/(1-MPC)

multiplier of J= 1/(1-.75)=4

multiplier of K= 1/(1-.5)=2

A tax cut will increase the aggregate expenditure (aggregare demand) of J economy 4 times and by 2 times for K.

The answer is J

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