Question

1)Suppose the consumption function is

      C = $414 billion + 0.9Y

If the government increases spending on new goods and services by $50 what is amount of the cumulative shift in AD? Enter your answer in whole numbers. For example, if your answer is $450.25 then enter 450

2)

Suppose the government decides to increase taxes by $30 billion to increase Social Security benefits by the same amount. How will this combined tax transfer policy effect aggregate demand at current prices if the MPC is 0.8?

$80 billion

$150 billion

no change

$30 billion

Answer 1

1) the marginal propensity to consume is 0.9. therefore the marginal propensity to save is 0.1 and the spending multiplier is 1 / mps = 1/0.1= 10. when government increases the spending on goods and services by $50, aggregate demand will shift by ∆G*multiplier which is 50*10 = 500

2) there should be no change in the income or the aggregate demand because an increase in the taxes and an increase in transfer payment by the same amount will nullify each other thereby bringing no change in the disposable income.