Question

The U.S. economy slowed significantly in early 2008 , and policy makers were extremely concerned about growth. To boost the economy, Congress passed several relief packages (the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009) that combined would deliver about \(\$ 700\) billion in government spending. Assume, for the sake of argument, that this spending was in the form of payments made directly to consumers. The objective was to boost the economy by increasing the disposable income of American consumers. a. Calculate the initial change in aggregate consumer spending as a consequence of this policy measure if the marginal propensity to consume \((M P C)\) in the United States is \(0.5 .\) Then calculate the resulting change in real GDP arising from the \(\$ 700\) billion in payments. b. Illustrate the effect on real GDP with the use of a graph depicting the income-expenditure equilibrium. Label the vertical axis "Planned aggregate spending, \(A E_{\text {Planned }}\) " and the horizontal axis "Real GDP." Draw two planned aggregate expenditure curves \(\left(A E_{\text {Planned } 1}\right.\) and \(A E_{\text {Planned } 2}\) ) and a 45 -degree line to show the effect of the autonomous policy change on the equilibrium.

Short answer

Answer: The change in real GDP resulting from a \$700 billion stimulus package with a marginal propensity to consume (MPC) of 0.5 is \$700 billion.

Step-by-step solution

Calculate the initial change in aggregate consumer spending

To calculate the initial change in aggregate consumer spending, we will start by looking at the marginal propensity to consume (MPC). In this exercise, the MPC is given as 0.5 which means that for every dollar received, consumers will spend 50 cents. The government has provided a total of \(\$700\) billion to consumers as part of the stimulus packages. To calculate the initial change in aggregate consumer spending, we follow this formula: Initial Change in Aggregate Consumer Spending = MPC × Total Stimulus Package

Calculate the initial change in consumer spending

Using the given MPC of 0.5 and the total stimulus package of \(\$700\) billion, we can find the initial change in aggregate consumer spending: Initial_agg_consumer_spending = MPC × Total_stimulus Initial_agg_consumer_spending = 0.5 × 700 Initial agg_consumer_spending = \(\$ 350\) billion So, the initial increase in aggregate consumer spending due to this policy measure is \(\$350\) billion.

Calculate the change in real GDP

To find the change in real GDP as a result of this increased consumer spending, we use the spending multiplier formula: Spending Multiplier = 1 / (1 - MPC) We can now calculate the spending multiplier with the provided MPC: Spending_multiplier = 1 / (1 - 0.5) Spending_multiplier = 2 Now we can find the change in real GDP as a result of this increase in consumer spending: Change_in_real_GDP = Initial_agg_consumer_spending × Spending_multiplier Change_in_real_GDP = 350 × 2 Change_in_real_GDP = \(\$ 700\) billion Hence, the resulting change in real GDP arising from the \(\$700\) billion in payments is also \(\$700\) billion.

Illustrate the effect on real GDP in a graph

To show the effect of this autonomous policy change on the equilibrium, we can draw a graph that has the planned aggregate spending on the vertical axis, real GDP on the horizontal axis, and two aggregate expenditure curves (\(AE_{Planned1}\) and \(AE_{Planned2}\)). We begin by drawing our axes with proper labels, and then add a 45-degree line representing the point where planned aggregate spending equals real GDP. Next, draw the initial planned aggregate expenditure curve \(AE_{Planned1}\) such that it intersects the 45-degree line. This intersection point represents the initial equilibrium level of real GDP. Now, due to the stimulus packages, the planned aggregate expenditures increased by \(\$350\) billion, which led to an upward shift of the initial planned aggregate expenditure curve \(AE_{Planned1}\) to become \(AE_{Planned2}\). The new intersection point between the \(AE_{Planned2}\) curve and the 45-degree line represents the new equilibrium level of real GDP after the autonomous policy change. The horizontal difference between the initial and new equilibrium levels of real GDP represents the change in real GDP, which is equal to \(\$700\) billion, as we calculated in Step 3.

Key concepts

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is a crucial economic concept that describes how much of an additional dollar of income a consumer is likely to spend. It is expressed as a fraction and reflects consumer spending behavior.

For example, if the MPC is 0.5, it means that consumers will spend 50 cents of every additional dollar they receive. The rest, which is the remaining 50 cents in this case, would be saved or used to settle debts.

The MPC can have different values across different economies or even among different individuals in the same economy. A higher MPC suggests that consumers are more likely to spend a greater portion of any additional income, which can lead to more significant impacts on overall economic activities.

In fiscal policy, understanding the MPC helps government policymakers predict the impact of direct consumer stimulus packages. A high MPC indicates that injected funds will circulate more rapidly through the economy, while a low MPC might mean that the funds are more likely to be saved, resulting in less immediate economic stimulation.

Aggregate Consumer Spending

Aggregate consumer spending represents the total amount spent by all consumers in an economy on goods and services. It is a primary component of aggregate demand and has a significant influence on economic growth.

In fiscal policy measures, such as the stimulus packages discussed in the exercise, governments aim to directly increase this spending by boosting consumers' disposable income. For instance, in the given scenario, the government infused \(\\(700\) billion through direct payments to consumers.

With an MPC of 0.5, consumers initially spend half of this amount. This calculates to \(\\)350\) billion of increased immediate spending in the economy, enhancing overall demand. The intention is to spur economic activity without relying on long-term measures, hence tackling economic slowdowns rapidly.

It is essential to understand that aggregate consumer spending drives business decisions, employment rates, and, ultimately, the entire economy's growth rate. An increase in consumer spending signals businesses to increase production, hire more workers, and invest in new projects, creating a virtuous cycle of economic expansion.

Spending Multiplier

The spending multiplier describes how an initial change in spending leads to a more than proportional change in the overall real GDP. It is a powerful concept in fiscal policy because it highlights how government spending influences the economy's total output.

Calculating the spending multiplier involves the formula: \( \text{Spending Multiplier} = \frac{1}{1 - MPC} \). For the problem at hand, with an MPC of 0.5, the spending multiplier is 2.

This means every dollar of initial consumer spending will generate an additional dollar in economic activity, resulting in a total change in GDP that is twice the initial spending amount.

Therefore, the \(\\(350\) billion increase in consumer spending, due to the initial stimulus, yields a \(\\)700\) billion increase in real GDP after accounting for the multiplier effect.

The spending multiplier effect is a key consideration for policymakers when designing economic stimulus packages, as it enables them to predict how different spending amounts and types will ripple through the economy, thus optimizing their approach to inducing economic growth.