Question

Consider Figure 12-7, which applies to an economy in which the marginal propensity to consume is 0.8. Why does a \(0.1 trillion increase in planned real investment spending cause the aggregate demand curve to shift rightward by exactly \)0.5 trillion at the initial equilibrium price level of 110?

Short answer

It is due to the multiplier effect

Step-by-step solution

introduction

Multiplier estimates the impact of an adjustment of any exogenous variable fair and square of GDP or result. It shows how much the total result (Y) changes for a given change in independent variables, for example, investment, government spending, and so forth.

explanation

We know,

change in autonomous variables = $∆A$

change in real GDP = $∆Y$

mpc = marginal propensity to consume

Multiplier size = $\mathrm{\Delta Y}=\frac{\mathrm{\Delta A}}{1-\mathrm{mpc}}$

localid="1651931995158" $\frac{\mathrm{\Delta Y}}{\mathrm{\Delta A}}=\frac{1}{0.2}=5$

Change in income = $5\times 0.1$= $\$5$trillion

This causes the aggregate demand curve to shift rightward by exactly $\$0.5$trillion at the initial equilibrium price level of$110$