Scenario 34-2. The following facts apply to a small 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. In response to which of the following events could aggregate demand increase by $1,500?
A)A stock-market boom stimulates consumer spending by $300, and there is an operative crowding-out effect.
B)A stock-market boom stimulates consumer spending by $550, and there is a small operative crowding-out effect.
C)An economic boom overseas increases the demand for U.S.net exports by $550, and there is no crowding-out effect.
D)An economic boom overseas increases the demand for U.S.net exports by $300, and there is no crowding-out effect.

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) can be calculated as the change in consumption divided by the change in income, which is ($7,040 - $6,720) / ($8,500 - $8,000) = 0.64. To increase aggregate demand by $1,500, the initial increase in spending must be larger due to the multiplier effect. With an MPC of 0.64, the multiplier is 1/(1-0.64) = 2.78. Therefore, an initial increase in spending of $550 would result in an increase in aggregate demand of $550 * 2.78 = $1,529, which is close to $1,500, considering a small crowding-out effect.