Question

Following the rightward shift in the aggregate demand curve generated by the \( 0.1 trillion rises in real planned investment spending in Problem 12-18, why does the actual equilibrium level of real GDP increase by only \)0.3 trillion instead of $0.5 trillion?

Short answer

the actual equilibrium level of real GDP increased by only $\$0.3$trillion instead of $\$0.5$ trillion due to crowding-out effect.

Step-by-step solution

introduction

Crowding out impact alludes to a situation where the rise in the price level or interest rates hoses the initial increase in investment or government spending.

explanation

The aggregate demand curve shifts because of an adjustment of any of the independent variables at a given price level. The size of the shift is given by the multiplier times the adjustment of the independent variable.

The aggregate demand increases by $\$0.5$trillion as investment increases by $\$0.1$trillion. However, when the price level rises from $\$110$to $\$115$, a piece of the initial increase in aggregate demand is crowded out. This is given by a development up along the aggregate demand curve. This is the reason the real GDP increases by just $$0.3$ trillion instead of $$0.5$ trillion.