Question

3.     Aggregate supply and aggregate demand in Lithuania were in their long run equilibrium. Then consumers decided to spend less and save more.

Suppose that the Lithuanian government decided to increase government spending by 50 million Euro to try to offset the decrease in consumer spending.

                                              i. Explain how this might increase aggregate demand by more than 50 million Euro (3 points).

                                            ii. Explain how this might increase aggregate demand by less than 50 million Euro (3 points).

Answer 1

There are four factors of aggregate demand viz disposable income, the investment which is a function of interest rate, government spending, and the net exports. Coming to the third-factor government spending it has a positive impact on the aggregate demand. The government spending will certainly increase the aggregate demand but the increase in aggregate demand may not be equal to government spending. It depends on how many times government spending has been used to demand goods and services in an economy. Suppose $1 has been circulated by the government, with this $1 a traveler ate an omelet from a roadside stall, the stall owner bought 2 eggs from a farmer, the farmer bought 1 kg chicken feeds from another shop keeper who finally deposited it in the bank. In this case, the government spending of $1 has increased the aggregate demand by three times. Here three is the multiplier. Accordingly:

i-If the multiplier is more than one the government spending of 50 million euro will increase the aggregate demand by more than 50 million euro

ii-If the multiplier is less than one, the government spending of 50 million euro will increase the aggregate demand by less than 50 million euro