6. The multiplier effect of a change in government purchases

Consider a hypothetical closed economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25.

The marginal propensity to consume (MPC) for this economy is_________ , and the spending multiplier for this economy is __________ .

Suppose the government in this economy decides to increasegovernment purchases by $250 billion. The increase in government purchases will lead to an increase in income, generating an initial change in consumption equal to____________. This increases income yet again, causing a second change in consumption equal to___________________. The total change in demand resulting from the initial change in government spending is _______________ .

The following graph shows the aggregate demand curve (AD1) for this economy before the change in government spending.

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."

Hint: Be sure that the new aggregate demand curve (AD2) is parallel to the initial aggregate demand curve (AD1). You can see the slope of AD1by selecting it on the graph.

140 A AD 135 AD , 130 125 120 PRICE LEVEL 115 110 105 100 8 0 1 2 3 4 5 6 7 OUTPUT (Trillions of dollars)