Question

Assume the economy is in recession and real GDP is below full employment. The marginal propensity to consume (MPC) is 0.80, and the government increases spending by $500 billion. As a result, aggregate demand will rise by a. zero. b. $2,500 billion. c. more than $2,500 billion. d. less than $2,500 billion.

Answer 1

Answer:

Option (b) is correct.

Explanation:

Given that,

Marginal propensity to consume (MPC) = 0.80

Government increases spending by $500 billion.

Change in aggregate demand is determined by multiplying the spending multiplier with the change in government spending.

Spending multiplier:

$=\frac{1}{1-MPC}$

$=\frac{1}{1-0.8}$

= $\frac{1}{0.2}$

= 5

Therefore, as a result of increase in the government spending, the aggregate demand will rise by:

= Spending multiplier × Change in government spending

= 5 × $500 billion

= $2,500 billion