4. The multiplier effect of a change in government purchases Suppose there is some 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 decrease government purchases by $250 billion. The decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to This decreases income yet again, leading to a second change in consumption equal to is The total change in demand resulting from the initial change in government spending 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 (ADI). You can see the slope of AD1 by selecting it on the graph. PRICE LEVEL 140 135 AD 130 10 125 120 115 110 105 100 0 1 2 3 4 5 OUTPUT (Trillions of dollars) 6 8 A AD₂ (?)
4. The multiplier effect of a change in government purchases Suppose there is some 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 decrease government purchases by $250 billion. The decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to This decreases income yet again, leading to a second change in consumption equal to is The total change in demand resulting from the initial change in government spending 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 (ADI). You can see the slope of AD1 by selecting it on the graph. PRICE LEVEL 140 135 AD 130 10 125 120 115 110 105 100 0 1 2 3 4 5 OUTPUT (Trillions of dollars) 6 8 A AD₂ (?)
Chapter11: Fiscal Policy
Section: Chapter Questions
Problem 1.4P
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Transcribed Image Text:4. The multiplier effect of a change in government purchases
Suppose there is some 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 decrease government purchases by $250 billion. The decrease in government spending will lead
to a decrease in income, creating an initial change in consumption equal to
This decreases income yet again, leading to a
second change in consumption equal to
is
The total change in demand resulting from the initial change in government spending
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 (ADI). You can see the slope of AD1 by
selecting it on the graph.
PRICE LEVEL
140
135
AD
130
10
125
120
115
110
105
100
0
1
2
3
4
5
OUTPUT (Trillions of dollars)
6
8
A
AD₂
(?)
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