Question

3. The multiplier effect of a change in government purchases 

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 spending 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 (AD1 ) for this economy before the change in government spending. 

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2 ) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out." 

Hint: Be sure that the new aggregate demand curve (AD2 ) is parallel to the initial aggregate demand curve (AD). You can see the slope of AD by selecting it on the graph. 

Answer 1

(-ve sign indicates decrease)

First change in consumption = - 300 x 0.7 = - $ 210 bn

Second change in consumption = -210 x 0.7 = - $ 147 bn

Total change in demand = -300 x 3.33 = - $ 1000 bn or - $ 1 tn