The multiplier effect of a change in government purchases Consider a hypothetical closed economy in which households spend $0.70 of each additional dollar they earn and save the remaining $0.30.
- The marginal propensity to consume (MPC) for this economy is , and the spending multiplier for this economy is.
- Suppose the government in this economy decides to increase government purchases by $300 billion. The increase in government purchases will lead to an increase in income, generating an initial change in consumption equal to. This increases income yet again, causing a second change in consumption equal to. The total change in demand resulting from the initial change in government spending is .
- The following graph shows the aggregate demand curve (AD1 ) for this economy before the change in government spending.
Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2 ) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."
Hint: Be sure that the new aggregate demand curve (AD2 ) is parallel to the initial aggregate demand curve (AD1 ). You can see the slope of AD1 by selecting it on the graph. AD 2 0 1 2 3 4 5 6 7 8 140 135 130 125 120 115 110 105 100 PRICE LEVEL OUTPUT (Trillions of dollars) AD 1.