Question

Assume the mpc=.55. What will the total impact on the AD be equal to ( consider both direct and indirect effect) when there is a $400 billion increase in government spending? Also, compare the overall change in Y in short-run and long-run equilibrium ( use AS, SRAS and LRAS)

Answer 1

From the marginal propensity to consume we can calculate the value of a spending multiplier which is given by 1/1-mpc = 1/1-0.55 if there is an increase of 400 billion dollars of government is spending then equilibrium income will be increased by 400 *2.22= 888.88 billion dollars

When this is drawn in the short run aggregate demand and aggregate supply situation we observe that aggregate demand shifts to the right by 888.88 billion dollars. However because long run aggregate supply and short run aggregate supply are also present, much of this increase is absorbed by increasing prices so that GDP is not entirely increased by 888.88 billion dollars but by amount less than this. Therefore the overall change in the income is less than what multiplier suggest.