Question

Assume the marginal propensity to consume \((M P C)\) is 0.75 and the government increases taxes by \(\$ 250\) billion. The aggregate demand curve will shift to the a. left by \(\$ 1,000\) billion. b. right by \(\$ 1,000\) billion. c. left by \(\$ 750\) billion. d. right by \(\$ 750\) billion.

Short answer

The aggregate demand curve will shift to the left; however, none of the given options match the calculated change in consumption of -\$187.5 billion. Therefore, we cannot determine the correct answer from the provided options.

Step-by-step solution

Calculate the change in disposable income

First, we need to calculate the change in disposable income as a result of the increase in taxes. Since taxes are increased by \(250 billion, disposable income will decrease by the same amount: \)\$ 250$ billion.

Calculate the change in consumption

Now, we can calculate the change in consumption that occurs due to the change in disposable income. We can use the marginal propensity to consume (MPC) for this: Change in consumption = MPC × Change in disposable income Change in consumption = 0.75 × (-\(250\) billion) = -\(187.5\) billion #Step 2: Determine the direction of the shift in the aggregate demand curve#

Understand the impact of the change in consumption on aggregate demand

Since consumption is a component of aggregate demand, a decrease in consumption will lead to a decrease in aggregate demand. This will result in a shift of the aggregate demand curve to the left. #Step 3: Identify the correct answer choice#

Compare the change in consumption with the given options

As we calculated in Step 1, the change in consumption is -\(187.5\) billion. Now, let's find which answer choice matches this value. a. left by \(\$ 1,000\) billion: This option does not match our calculated value. b. right by \(\$ 1,000\) billion: This option is not applicable, as we know the aggregate demand curve shifts to the left. c. left by \(\$ 750\) billion: This option does not match our calculated value. d. right by \(\$ 750\) billion: This option is not applicable, as we know the aggregate demand curve shifts to the left. None of the given options match the calculated change in consumption of -\(187.5\) billion. Therefore, based on the given information, we cannot determine the correct answer from the provided options.

Key concepts

The Marginal Propensity to Consume

Understanding the marginal propensity to consume (MPC) is essential for evaluating how economic policy, such as taxation, can affect spending habits and overall economic activity. The MPC represents the fraction of an additional dollar of disposable income that households are likely to consume rather than save. For example, an MPC of 0.75 means that for every extra dollar received, 75 cents would be spent on consumption.

The MPC is crucial because it helps us determine the multiplier effect, which is the amplified impact on aggregate demand due to a change in income. A higher MPC indicates a stronger reaction in consumption to a change in income and thus a larger multiplier effect. Conversely, a lower MPC suggests a smaller change in consumption and a weaker multiplier effect. The relationship between MPC and the multiplier effect illustrates how individual spending behavior can translate into significant shifts in economic output.

Disposable Income and Economic Activity

Disposable income, simply put, is the amount of money households have available for spending and saving after income taxes have been accounted for. It is a critical determinant of consumption since it represents the actual earnings that can be used by consumers for their expenses.

The economic well-being of a nation is often gauged by the changes in the level of disposable income over time. When consumers have more disposable income, they are more likely to spend, which in turn drives up demand for goods and services, leading to economic growth. On the flip side, when disposable income decreases due to higher taxes or wage cuts, consumers tend to spend less, which can slow down economic growth. Understanding how disposable income changes helps economists and policymakers predict consumer behavior and craft appropriate fiscal policies.

Taxation's Impact on the Economy

Taxation policies significantly influence the economy by altering disposable income levels and, consequently, consumption and savings. When the government imposes higher taxes, disposable income decreases, leading to reduced consumer spending and a potential slowdown in the economy.

However, taxation isn't just a tool for revenue generation. It can also serve as a means to redistribute wealth, encourage or deter certain investments, and manage inflation. The overall impact of taxation on the economy depends on the structure of the tax system, the timing of tax changes, and how taxpayers respond to these changes. For instance, an increase in taxes during an economic boom can help cool off an overheated economy, while the same action during a recession could exacerbate the downturn.

Consumption Changes in Economics

Consumption is a fundamental economic variable representing the end-use of goods and services by households. Changes in consumption patterns can significantly impact aggregate demand and economic stability. Economic theories suggest that consumption changes in response to several factors, including disposable income, consumer confidence, interest rates, and inflation expectations.

A crucial aspect to monitor is how these factors influence consumer decisions. A rise in consumer confidence, for instance, might lead to more spending regardless of disposable income changes. Conversely, high-interest rates can discourage spending on credit, while expectations of inflation might prompt consumers to spend sooner rather than later to avoid higher future prices.