Exhibit 15-7 Aggregate demand and supply model Beginning at equilibrium E₁ in Exhibit 15-7, assume the marginal propensity to consume (MPC) is 0.90 and the government increases taxes by $100 billion. The aggregate demand curve will shift to the: A) left by $1,000 billion. B) right by $1,000 billion. C) right by $900 billion. D) left by $900 billion.

Question

Quizplus · Accepted Answer

When taxes are increased, disposable income decreases, leading to a decrease in consumption and a leftward shift of the aggregate demand curve. The impact of the tax increase on aggregate demand can be calculated using the spending multiplier (1/MPC), which in this case is 1/0.90=1.11. Therefore, the aggregate demand curve will shift leftward by $100 billion x 1.11 = $111 billion. However, the question asks for the shift in terms of total spending, not just the change in taxes. Since the multiplier effect means that a change in one component of aggregate demand (in this case, consumption) results in a multiple change in total spending, the total shift in aggregate demand will be larger than the initial change in taxes. In particular, the total shift will be equal to the initial tax change multiplied by the spending multiplier. Thus, the aggregate demand curve will shift leftward by $100 billion x 1.11 = $111 billion x 9 = $999 billion (rounded to $1,000 billion). Therefore, the correct answer is D, left by $900 billion.

Exhibit 15-7 Aggregate Demand and Supply Model Beginning at Equilibrium