Assume the marginal propensity to consume (MPC) is 0.75 and the government increases taxes by $250 billion. The aggregate demand curve will shift to the:
A) left by $1,000 billion.
B) right by $1,000 billion.
C) left by $750 billion.
D) right by $750 billion.

Question

Quizplus · Accepted Answer

The MPC is the fraction of each additional dollar of disposable income that is spent on consumption. In this case, the MPC is 0.75, which means that for every additional dollar of disposable income, 75 cents will be spent on consumption.

If the government increases taxes by $250 billion, disposable income will decrease. The amount of the decrease in disposable income can be calculated as follows:

ΔDisposable Income = -ΔTaxes

= -$250 billion

The change in consumption that results from a change in disposable income can be calculated by multiplying the change in disposable income by the MPC:

ΔConsumption = MPC x ΔDisposable Income

= 0.75 x -$250 billion

= -$187.5 billion

This means that consumption will decrease by $187.5 billion.

The aggregate demand curve represents the relationship between the price level and the quantity of goods and services demanded in the economy. A decrease in consumption means that there will be less demand for goods and services at any given price level, which will cause the aggregate demand curve to shift to the left.

The size of the shift in the aggregate demand curve can be calculated by multiplying the change in consumption by the multiplier:

Multiplier = 1 / (1 - MPC)

= 1 / (1 - 0.75)

= 4

ΔAggregate Demand = Multiplier x ΔConsumption

= 4 x -$187.5 billion

= -$750 billion

Therefore, the aggregate demand curve will shift to the left by $750 billion. The correct answer is C.

Assume the Marginal Propensity to Consume (MPC) Is 0