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Suppose economists observe that an increase in government spending of \$10 billion raises the total demand for goods and services by \$30 billion.a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume ($MPC$) to be?b. Now suppose the economists allow for crowding out. Would their new estimate of the $MPC$ be larger or smaller than their initial one?
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Chapter 34
The Influence of Monetary and Fiscal Policy on Aggregate Demand
The Real Economy in the Long Run
Money and Prices in the Long Run
Short-Run Economic Fluctuations
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Suppose economists observe…
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in question seven. We're being asked to consider the following scenario. Suppose economists observed that an increase in government spending of $10,000,000,000 raises the total demand for goods and services by $30,000,000,000. Party says if this economists ignoring the possibility of crowding out, what would they estimate the marginal propensity to consume? To be all right to begin with, let's recall that the effect of Carmen spending on aggregate demand is twofold. On the one hand, we have a positive impact of government spending through the fiscal multiplier effect. No. The other hand, we have a negative impact through the crowding out effect which results from a nen crease in the liberal interest rate for party were totally ignoring the possibility of crowding out. So essentially, we're dealing with a pure multiplier effect. All right, we've been given that the change in agreed demanded by by government's paying is equal to 30 over 10 which is equal to three, and this implies that the value of the multiplier is equal to three. Now we know from our standard formula for the multiplier that it is equal to the infinite. Some of the Marshall prevents to consume and since the MPC streaked the lesson one this infinite. Some converge ist one over one minus NPC and this is equal to three. So we solve this simple equation. We get estimates for the embassy to be 2/3. All right. Part of me says no, supposed the economy's allow for crowding out with the new estimate of the MP CB, larger or smaller on the initial want their initial one. Well, we we got a standard formulas down. We have everything we need to know. But the only difference will be that here in this equation, we will add We will include the crowding out effect which enters with negative signs. As we explained, this is a drag on agree demand as opposed to ah, increased by the multiplier effect. So if we substitute in our formula for the fiscal multiplier, we get one over one. Mine is NBC's equal to three pleasant crabbing out, and this implies that the marginal propensity to consume and this case will be larger than 2/3. And this actually makes a lot of sense, because if you think about it, um, an NPC that is larger than 2/3 would lead to a larger multiplier higher than three. But then this is reduced down to three by the crowding out effect. Thus we're getting multipliers three.
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