The multiplier effect of a change in government purchases Consider a hypothetica

Question

The multiplier effect of a change in government purchases Consider a hypothetical closed economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25. 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 increase government purchases by $250 billions. The increase in government purchases will lead to an increase in income,generating an initial change in consumption equal to_________?.This increases 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(AD_1) for this economy before the change in government spending. Use the green line (triangle symbol) to plot the new aggregate demand curve (AD_2)after the multiplier effect takes place. For simplicity, assume that there is no "crowding cut"

Explanation / Answer

1. 0.75

2. Spending multiplier = 1/(1-MPC) = 1/(1-0.75) = 1/0.25 = 4

3. Initial change in consumption = 0.75 X 250 billion = 187.5 billion

4. Second change in consumption = 0.75 X 187.5 = 140.625 billion

5. Total Change in demand = Multiplier X Initial change in spending = 4 X 250 billion = $ 1000 billion

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