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 decreasegovernment purchases by $250 billion. The decrease in government purchases will lead to a decrease in income, generating an initial change in consumption equal to . This decreases 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 (AD1AD1) for this economy before the change in government spending.

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."

Hint: Be sure that the new aggregate demand curve (AD2AD2) is parallel to the initial aggregate demand curve (AD1AD1). You can see the slope of AD1AD1by selecting it on the graph.

AD2012345678140135130125120115110105100PRICE LEVELOUTPUT (Trillions of dollars)AD1