Question

7. Assume that the MPC is 0.9 and that the total crowding-out effect is $6 billion. Government purchases increase by $10 billion.

By how many billion will the aggregate demand shift?

In which direction?

Answer 1

Crowding-out : a decline in private consumption,investments and exports as a result of increase in government purchases.

MPC= marginal propensity to consume.

For an MPC=0.9, the government purchases multiplier will be

= 1/1-0.9

=10

A government purchase multiplier of 10 means that an increase in government spending of $10billion will result in increase equilibrium real GDP by 10 x $10billion = $100 billion but the crowding out effect will reduce it by $6 billion

So, the AD curve will shift to right by (100-6) = $94billion