Problem: Suppose that economists observe that in a closed economy an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.
1. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?
2. Now suppose that the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?
Suppose that the government of a closed economy reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4.
3. What is the initial effect of the tax reduction on aggregate demand?
4. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand?
5. How does the total effect of this $20 billion tax cut compare with the total effect of a $20 billion increase in government purchases? Why?