Question

Assume the economy is in recession and real GDP is below full employment. The marginal propensity to consume \((M P C)\) 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.

Short answer

The short answer is: The aggregate demand will rise by more than \(\$ 2,500\) billion.

Step-by-step solution

Identify the multiplier formula

The formula to calculate the multiplier is: \(Multiplier = \frac{1}{1-MPC}\)

Calculate the multiplier

Given the marginal propensity to consume (MPC) as 0.80, we can use the formula to calculate the multiplier: \(Multiplier = \frac{1}{1-0.80} = \frac{1}{0.20} = 5\)

Calculate the change in aggregate demand

Now that we have the multiplier, we can calculate the change in aggregate demand due to the increase in government spending. Change in Aggregate Demand = Multiplier × Change in Government Spending Change in Aggregate Demand = 5 × \(500\) billion.

Calculate the new amount of aggregate demand

Now, we can calculate the new amount of aggregate demand: New amount = 5 × \(500\) billion = \(2,500\) billion.

Determine the correct answer

Comparing our result with the given options, we find that the aggregate demand will rise by: c. more than \(\$ 2,500\) billion.

Key concepts

Marginal Propensity to Consume

The Marginal Propensity to Consume (MPC) is a crucial economic concept that reflects the portion of additional income that a consumer is likely to spend on goods and services, as opposed to saving it. In simpler terms, it tells us how much more people will consume when they earn a little extra.
Understanding MPC helps in predicting consumer behavior and the overall economic growth. For example:

• If the MPC is 0.80, it means that for every extra dollar earned, a consumer will spend 80 cents and save 20 cents.
• A higher MPC indicates that people are likely to spend more of their additional income, which can boost the economy's demand side.
• Conversely, a lower MPC suggests more stringent saving habits, which might limit economic growth.

Aggregate Demand

Aggregate Demand (AD) represents the total demand for goods and services within an economy at a given overall price level and within a specified time period. It is a critical component in understanding economic fluctuations.
Aggregate Demand is influenced by several factors, including:

• Consumer spending, which is directly impacted by the Marginal Propensity to Consume.
• Investment by businesses, government spending, and net exports.
• Government policies, such as tax cuts or increased spending, which can shift AD.

For instance, if consumer spending increases due to a higher MPC, aggregate demand will rise, potentially leading to economic growth. Conversely, in a recession, reducing taxes or increasing government expenditure can stimulate AD, mitigating the slowdown.

Government Spending

Government Spending is a vital instrument used by governments to influence their country's economy. It involves expenditures on goods and services, including infrastructure, health care, and education.
When governments increase spending, this often stimulates economic activity by boosting aggregate demand. Key points on government spending include:

• It can create jobs and reduce unemployment by generating demand for goods and services.
• Spending on infrastructure can lead to long-term economic benefits, improving efficiency and productivity.
• During a recession, like in the given problem, increased government spending can offset reduced private sector activity and help return the economy to full employment.

Full Employment

Full Employment is an economic situation where all available labor resources are being used efficiently. It does not mean a zero unemployment rate, but rather an unemployment rate that includes only frictional and structural unemployment.
This concept is essential for understanding economic health, characterized by:

• High GDP levels where the economy is operating at its maximum potential output.
• A stable inflation rate because excessive demand in full-employment conditions can lead to inflation.
• Economic policies aim to achieve this state, as it signifies robust economic activity and prosperity.

In the exercise scenario, achieving full employment is the ultimate goal of increased government spending during a recession, aimed at boosting aggregate demand and utilizing unused labor resources.