Question

If no fiscal policy changes are implemented, suppose the future aggregate demand curve will shift and exceed the current aggregate demand curve by \(\$ 900\) billion at any level of prices. Assuming the marginal propensity to consume \((M P C)\) is \(0.90,\) this increase in aggregate demand could be prevented by a. increasing government spending by \(\$ 500\) billion. b. increasing government spending by \(\$ 140\) billion. c. decreasing taxes by \(\$ 40\) billion. d. increasing taxes by \(\$ 100\) billion.

Short answer

The best choice among the given options is to decrease taxes by \(\$ 40\) billion, as it comes closest to the required change in fiscal policy and will soften the increase in aggregate demand compared to the original situation.

Step-by-step solution

Calculate the multiplier

To calculate the multiplier, use the following formula: \[Multiplier = \frac{1}{1 - MPC}\] Given that the MPC is \(0.90\), substitute into the formula: \[Multiplier = \frac{1}{1 - 0.90} = \frac{1}{0.10} = 10\]

Calculate the change in government spending or taxes

With the multiplier calculated, we can determine the required change in government spending or taxes to prevent the increase in aggregate demand: \[Change\,in\,Fiscal\,Policy = \frac{Change\,in\,Aggregate\,Demand}{Multiplier}\] Substitute the values: \[Change\,in\,Fiscal\,Policy = \frac{900}{10} = 90\] A fiscal policy change of \(90\) billion is required to prevent the increase in aggregate demand. Now, let's investigate each of the given options to determine which one is correct.

Identify the correct answer

a. increasing government spending by \(500\) billion: This would have a \(10 \times \$500=\$5000\) billion impact on aggregate demand, which is not required. b. increasing government spending by \(140\) billion: This would have a \(10 \times \$140=\$1400\) billion impact on aggregate demand, which is also not required. c. decreasing taxes by \(40\) billion: This would have a \(10 \times \$40=\$400\) billion impact on aggregate demand. It would not prevent the increase in aggregate demand, as the required policy change needs to have an impact of \(90\) billion. d. increasing taxes by \(100\) billion: This option would have a -\(10 \times \$100=-\$1000\) billion impact on aggregate demand. This means that it would prevent the increase in aggregate demand, but it would also create a decrease in aggregate demand that is larger than necessary. None of the given options exactly matches the required fiscal policy change of \(90\) billion. However, option (c) - decreasing taxes by \(40\) billion - comes closest to the required change, as it will soften the increase in aggregate demand compared to the original situation. Therefore, the best choice among these options is: **c. decreasing taxes by \(\$ 40\) billion.**

Key concepts

Aggregate Demand

Aggregate demand represents the total amount of goods and services demanded in an economy at a given overall price level and in a given time period. It reflects the spending intentions of different participants in the economy, such as households, businesses, and the government.

Understanding aggregate demand is critical for assessing economic health. When aggregate demand increases, it typically leads to higher output and employment. Conversely, a decrease might indicate an economy heading towards recession, with potential reductions in output and rising unemployment.

Aggregate demand is driven by several components, including:

• Consumption: Expenditure by households on goods and services.
• Investment: Spending on capital goods that will be used for future production.
• Government Spending: Spending on goods and services by the government.
• Net Exports: Exports minus imports.

Fiscal policies, like adjustments in government spending and taxes, are tools used to influence aggregate demand. Policymakers adjust these tools to help stabilize the economy by trying to match aggregate demand with potential output.

Marginal Propensity to Consume (MPC)

The Marginal Propensity to Consume (MPC) is a key concept in understanding how households might alter their spending when they experience changes in income. It indicates the proportion of additional income that a household would spend rather than save.

Mathematically, if an individual's income increases by a certain amount, the MPC demonstrates the fraction of this increase that will be consumed. For instance, if the MPC is 0.90, it implies that for every additional dollar of income, 90 cents will be spent on consumption while 10 cents are saved.

MPC is crucial in macroeconomic models because:

• It helps predict consumer behavior in response to economic changes.
• It is used to calculate the multiplier effect, which amplifies changes in fiscal policy on aggregate demand.
• Higher MPC suggests a larger effect of consumption on the economy since more income translates to more spending.

Understanding the MPC enables policymakers to forecast the impacts of fiscal interventions and plan effective measures to stabilize the economy.

Multiplier Effect

The multiplier effect describes the impact of a change in economic activity, such as government spending or fiscal policy, on the total economy. A one-unit increase in spending can lead to a more significant overall increase in the economy – that's the power of the multiplier effect.

The multiplier is calculated using the formula:\[ \text{Multiplier} = \frac{1}{1 - \text{MPC}} \]A high MPC means a higher multiplier, indicating that small changes in spending can lead to large changes in total economic output. In our scenario, with an MPC of 0.90, the multiplier is 10.

Why does this matter?

• It shows how initial spending, like government infrastructure projects, can increase aggregate demand beyond the initial outlay.
• It helps assess the real impact of fiscal policies on the economy.
• Understanding the multiplier effect aids in modeling economic outcomes and preparing for future shifts in economic conditions.

The concept of the multiplier effect is vital for crafting effective fiscal policies that set balanced economic growth and address potential downturns.