Scenario 34-2.The following facts apply to a small,imaginary economy.
• Consumption spending is $6,720 when income is $8,000.
• Consumption spending is $7,040 when income is $8,500.
-Refer to Scenario 34-2.For this economy,an initial increase of $500 in government purchases translates into a
A)$1,388.89 increase in aggregate demand in the absence of the crowding-out effect.
B)$3,125.00 increase in aggregate demand in the absence of the crowding-out effect.
C)$1,135 increase in aggregate demand when the crowding-out effect is taken into account.
D)$3,125.00 increase in aggregate demand when the crowding-out effect is taken into account.

Question

Quizplus · Accepted Answer

The multiplier is (1/1-MPC), where MPC is the marginal propensity to consume. In this case, MPC is (7,040-6,720)/(8,500-8,000) = 0.64. Therefore, the multiplier is 1/1-0.64 = 2.78. An increase of $500 in government purchases will therefore increase aggregate demand by $500 * 2.78 = $1,388.89.