Suppose the consumption function is C = $400 billion + 0.8 Y and the government

Question

Suppose the consumption function is C = $400 billion + 0.8Y and the government wants to stimulate the economy. By how much will aggregate demand at current prices shift initially (before multiplier effects) with

Instructions: Enter your response as a whole number.

(a) A $50 billion increase in government purchases? $......... billion

Instructions: Enter your responses rounded to one decimal place.

(b) A $50 billion tax cut? $....... billion

(c) A $50 billion increase in income transfers? $........ billion

What will the cumulative AD shift be for

(d) The increased government spending? $........ billion

(e) The tax cut? $........ billion

(f) The increased transfers? $......... billion

Explanation / Answer

(a) C = 400 billion + 0.8Y

As government spending (Y) increases by $50 billion, consumption & AD increases by $50 billion x 0.8 = $40 billion.

(b) As tax falls by $50 billion, consumption & AD increases by $50 billion x 0.8 = $40 billion.

(c) As income increases by $50 billion, consumption & AD increases by $50 billion x 0.8 = $40 billion.

(d) Spending Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

$1 increase in government spending will increase AD by $5.

$50 billion increase in government spending will increase AD by $50 billion x 5 = $250 billion.

(e) Tax multiplier = - MPC / (1 - MPC) = - 0.8 / 0.2 = - 4

$1 decrease in tax will increase AD by $4.

$50 billion decrease in tax will increase AD by $50 billion x 4 = $200 billion.

(c) Spending Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

$1 increase in transfer income will increase AD by $5.

$50 billion increase in transfer income will increase AD by $50 billion x 5 = $250 billion.

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