Question

If no fiscal policy changes are implemented, suppose the future aggregate demand curve will exceed the current aggregate demand curve by \(\$ 500\) billion at any level of prices. Assuming the marginal propensity to consume \((M P C)\) is 0.80 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 \(\$ 125\) billion.

Short answer

The best option to prevent a \$500 billion increase in aggregate demand, given an MPC of 0.80, would be to increase taxes by \$125 billion (option d). This would create a decrease of \$625 billion in aggregate demand, effectively offsetting the increase.

Step-by-step solution

Understanding the multiplier effect

The multiplier effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon the household’s marginal decisions to spend, called the marginal propensity to consume or MPC, or to save, termed as the marginal propensity to save (MPS). Given that the MPC is 0.80, the MPS would be 1 - MPC = 0.20. The multiplier \( k \) can be calculated as: \( k = \frac{1}{MPS} \).

Calculate the Multiplier

Inserting our given value for MPS into the formula, we get \( k = \frac{1}{0.20} = 5 \).

Use the Multiplier to Evaluate the Options

As per the multiplier effect, a change of \$x in government spending or taxation will result in a \$k*x change in aggregate demand. Option a suggests increasing government spending by \$500 billion. This change would increase aggregate demand by \(5 * \$500\, billion = \$2500 \, billion \), which is too large; we’re aiming to prevent an increase of only \$500 billion. Option b proposes an increase in government spending by \$140 billion. This would increase aggregate demand by \(5 * \$140\, billion = \$700\, billion \), which is still more than our target of \$500 billion. Option c suggests a decrease in taxes by \$40 billion. This would increase disposable income, and thus consumption and aggregate demand, by \(5 * \$40 \, billion = \$200\, billion\), which is less than our target. Option d recommends an increase in taxes by \$125 billion. Interestingly, an increase in taxes reduces the amount of disposable income available for consumers, which decreases aggregate demand. This would result in a decrease of \( 5 * \$125\, billion = \$625\, billion \) in aggregate demand, effectively offsetting the increase.

Conclusion

The best option to prevent a \$500 billion increase in aggregate demand, given an MPC of 0.80, would be to increase taxes by \$125 billion (option d). This would create a decrease of \$625 billion in aggregate demand, effectively offsetting the increase.

Key concepts

Aggregate Demand

Aggregate demand represents the total demand for goods and services within an economy at different price levels and within a particular time frame. It encompasses consumption, investment, government spending, and net exports. Aggregate demand is crucial because it helps to understand the overall economic activity.
In macroeconomics, shifts in the aggregate demand curve can be caused by various factors such as changes in wealth, interest rates, fiscal policies, and expectations about future economic conditions.

• Consumption: The largest component of aggregate demand, driven by household spending.
• Investment: Spending by businesses on capital goods.
• Government Spending: Expenditures by the government on goods and services.
• Net Exports: The value of a country’s exports minus its imports.

Changes in any of these components can affect aggregate demand, which in turn impacts economic output, employment levels, and inflation.
In our exercise, changes brought about by fiscal policy can alter aggregate demand, and understanding this relationship is vital for economic stability.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is a measure of how much consumption increases when disposable income increases by one unit. It reflects the fraction of additional income that a household is likely to spend on consumption rather than saving.
For example, if the MPC is 0.80, this means that for every additional dollar received, a household is expected to spend 80 cents and save 20 cents. This proportion is crucial in calculating the multiplier effect in economics, where an initial change in spending results in a more significant change in the overall economy.
When the MPC is higher, the multiplier effect is stronger because households spend a larger portion of additional income, leading to more rounds of spending and re-spending in the economy. The formula for calculating the multiplier using MPC is: \[Multiplier (k) = \frac{1}{1 - MPC}\]In our exercise, with an MPC of 0.80, the multiplier is calculated as 5, indicating that any change in fiscal policy will have five times the effect on aggregate demand. Understanding the concept of MPC is essential to predicting how fiscal interventions will affect economic growth.

Fiscal Policy

Fiscal policy involves government spending and tax policies to influence economic conditions, including aggregate demand, employment, inflation, and economic growth.
Governments can use fiscal policy to either stimulate an economy (expansionary fiscal policy) or cool it down (contractionary fiscal policy). Here’s how:

• Government Spending: Increasing government expenditures can boost aggregate demand by directly injecting money into the economy.
• Taxation: Lowering taxes boosts disposable income for consumers and can increase consumption, thus raising aggregate demand. Conversely, increasing taxes can dampen consumption, reducing aggregate demand.

In the given exercise, altering fiscal policy by either increasing government spending or changing tax levels is explored to manage aggregate demand. Specifically, the challenge is to counteract a potential increase of $500 billion in aggregate demand, illustrating how carefully crafted fiscal policies can stabilize an economy. By calculating the effects of changes in spending or taxation using the multiplier effect, governments can achieve desired economic outcomes effectively.