Assume that the MPC is 0.8. Assume that there is a multiplier effect and that the total crowding-out effect is $8 billion. How will an increase in government purchases of $10 billion shift aggregate demand?
A) It will shift aggregate demand left by $2 billion.
B) It will shift aggregate demand left by $42 billion.
C) It will shift aggregate demand right by $2 billion.
D) It will shift aggregate demand right by $42 billion.

Question

Quizplus · Accepted Answer

The formula for the multiplier effect is 1/(1-MPC). If the multiplier effect is 8, then we can set up the equation:

8 = 1/(1-0.8)
8 = 1/0.2

This means that the initial change in government purchases of $10 billion will result in a total shift in aggregate demand of $80 billion (10 x 8).

Since the multiplier effect is positive, we know that the shift in aggregate demand will be to the right. Therefore, the correct answer is D: it will shift aggregate demand right by $42 billion (80/2).

Assume That the MPC Is 0