Question

Assume that an economy starts at $4 trillion in output and a price level of 50. Military spending then increases by $1 trillion. The marginal propensity to consume is 0.75.

Assuming no crowding-out effect, what is the level of aggregate demand at a price level of 50 after the increased military spending and the multiplier effect?

a. $1 trillion

b. $4 trillion

c. $6 trillion

d. $8 trillion

Answer 1

Multiplier = 1/(1-MPC) = where MPC = Marginal propensity to consume = 0.75

=> Multiplier = 1/(1-0.75) = 4

This means that $1 increase in autonomous expenditure(like government military spending) will result in increase in aggregate output and thus Aggregate demand(as there is no crowding out) by $4. So, $1 trillion increase in military spending will result in increase in Aggregate demand by 4*1 trillion = $4 trillion.

So, At price level of 50, the level of aggregate demand = 4 trillion + 4 trillion = $8 trillion

Hence, the correct answer is (d) $8 trillion