Assume that the MPC is 0.8. Assume that there is a multiplier effect and that the total crowding-out effect is $7 billion. How will an increase in government purchases of $8 billion shift aggregate demand?
A)It will shift aggregate demand left by $1 billion.
B)It will shift aggregate demand left by $33 billion.
C)It will shift aggregate demand right by $1 billion.
D)It will shift aggregate demand right by $33 billion.

Question

Quizplus · Accepted Answer

The multiplier effect amplifies the initial increase in government purchases, so the total increase in aggregate demand will be greater than the initial $8 billion. To calculate the total increase in aggregate demand, we use the formula:

Multiplier = 1 / (1 - MPC)
Multiplier = 1 / (1 - 0.8)
Multiplier = 5

Total increase in aggregate demand = Initial increase x Multiplier
Total increase in aggregate demand = $8 billion x 5
Total increase in aggregate demand = $40 billion

However, the total crowding-out effect of $7 billion reduces the net increase in aggregate demand to:

Net increase in aggregate demand = Total increase - Crowding-out effect
Net increase in aggregate demand = $40 billion - $7 billion
Net increase in aggregate demand = $33 billion

Since the government purchases are increasing, the direction of aggregate demand shift will be to right. Therefore, the correct answer is D.

Assume That the MPC Is 0