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
a) A $50 billion increase in government purchases?
$ billion
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 G?
$ billion
e) The tax cut?
$ billion
f) The increased transfers?
$ billion

Answer 1

Answer 2

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

a.   A $50 B increase in government purchases - With the Government increase in purchases of $50 billion the aggregate demand would increase by $50 billion.

b.   A $50 billion tax cut - $50B x .80 = $40B

1. A $50 billion increase in income transfers, What will the cumulative AD shirt be for - $50B x .80 = $40B

What will the cumulative AD shift be for:

1. The increased GDP - $50B x 10 = $500B
2. The Tax cut - $40B x 10 = $400B
3. The increased transfer - $40B x 10 = $400B

Answer 3

(a) Government purchase is a component of aggregate demand. Any increase in government purchases by a particular amount increases the aggregate demand by same amount as well and vice-versa.

So, before the multiplier effect will come into play, this increase of $50 billion in government spending will increase the aggregate demand by $50 billion as well.

(b) Tax cuts increases the disposable income of beneficiaries. However, this does not guarantee the spending of whole extra amount. How much of the increased income will be spent on consumption depends on MPC. Aggregate demand will initially be increased by this amount that will be spent on consumption taking into account the MPC.

In the given case, MPC is 0.80. So, out of $50 billion received as additional income due to tax cut, 80 percent will be spent on consumption that is $40 billion. So, before multiplier effect will come into play, this tax cut of $50 billion will increase the AD by $40 billion.

(c) Increase in income transfers increases the disposable income of beneficiaries. However, this does not guarantee the spending of whole extra amount. How much of the increased income will be spent on consumption depends on MPC. Aggregate demand will initially be increased by this amount that will be spent on consumption taking into account the MPC.

In the given case, MPC is 0.80. So, out of $50 billion received as additional income due to increase in income transfers, 80 percent will be spent on consumption that is $40 billion. So, before multiplier effect will come into play, this tax cut of $50 billion will increase the AD by $40 billion.

(d) Calculate cumulative increase in aggregate demand due to increase in government purchases by $50 billion –

Cumulative increase in \(\mathrm{AD}=\) Multiplier \(\times\) Initial increase in spending

$$ \begin{array}{l} =\frac{1}{1-\mathrm{MPC}} \times \$ 50 \text { billion } \\ =\frac{1}{1-0.80} \times \$ 50 \text { billion } \\ =\$ 250 \text { billion } \end{array} $$

Aggregate demand will increase by a total of $250 billion.

(e) Calculate cumulative increase in aggregate demand due to increase in consumption spending by $40 billion due to tax cuts of $50 billion –

Cumulative increase in \(\mathrm{AD}=\) Multiplier \(\times\) Initial increase in spending

$$ \begin{array}{l} =\frac{1}{1-\mathrm{MPC}} \times \$ 40 \text { billion } \\ =\frac{1}{1-0.80} \times \$ 40 \text { billion } \\ =\$ 200 \text { billion } \end{array} $$

Aggregated demand will increase by a total of $200 billion.

(f) Calculate cumulative increase in aggregate demand due to increase in consumption spending by $40 billion due to increase in income transfers by $50 billion –

Cumulative increase in \(\mathrm{AD}=\) Multiplier \(\times\) Initial increase in spending

$$ \begin{array}{l} =\frac{1}{1-\mathrm{MPC}} \times \$ 40 \text { billion } \\ =\frac{1}{1-0.80} \times \$ 40 \text { billion } \\ =\$ 200 \text { billion } \end{array} $$

Aggregated demand will increase by a total of $200 billion