Assume the marginal propensity to consume (MPC) is 0.80 and the government cuts taxes by $100 billion. The aggregate demand curve will shift to the:
A) right by $80 billion.
B) left by $200 billion.
C) right by $400 billion.
D) left by $400 billion.
E) None of the above.

Question

Quizplus · Accepted Answer

The formula for calculating the change in aggregate demand due to a change in government spending or taxes is ∆AD = MPC x ∆T, where ∆T is the change in taxes. In this case, the ∆T is $100 billion and the MPC is 0.80, so the ∆AD is 0.80 x $100 billion = $80 billion. However, since tax cuts lead to an increase in disposable income, which in turn leads to increased consumer spending, the actual change in aggregate demand will be greater than $80 billion. The multiplier effect will amplify the initial $100 billion tax cut by a factor of 1/ (1 - MPC) = 1/0.2 = 5. This means that the final change in aggregate demand will be 5 x $80 billion = $400 billion. Therefore, the aggregate demand curve will shift to the right by $400 billion.

Assume the Marginal Propensity to Consume (MPC) Is 0