If the marginal propensity to consume is 0.75, a $40 billion decrease in government purchases, all other things constant, would:
A)reduce consumption by $160 billion in the first round and overall aggregate demand by $640 billion.
B)reduce consumption by $120 billion in the first round and overall aggregate demand by $480 billion.
C)reduce consumption by $40 billion in the first round and overall aggregate demand by $160 billion.
D)reduce consumption by $30 billion in the first round and overall aggregate demand by$160 billion.
E)reduce consumption by $25 billion in the first round and overall aggregate demand by $640 billion.

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) is 0.75, meaning for every dollar decrease in income, consumption decreases by 75 cents. A $40 billion decrease in government purchases would reduce consumption by $30 billion in the first round (0.75 * $40 billion). The overall aggregate demand reduction is calculated using the multiplier effect, which is 1/(1-MPC) = 1/(1-0.75) = 4. Thus, the total reduction in aggregate demand is $40 billion * 4 = $160 billion.

If the Marginal Propensity to Consume Is 0