Question

Assume that the MPC is 0.8. Assume that the total crowding-out effect is $25 billion. How will an increase in government purchases of $9 billion shift the AD curve?

Answer 1

This is a change in government purchases, G. Since G is one component of aggregate demand, this increase will shift the AD curve to the right.There is a multiplier effect that tends to make it larger, and also a crowding-out effect that tends to make it smaller. The horizontal shift of AD would therefore be exactly same only if these two effects happened to exactly cancel each other.the multiplier effect works because any increase in purchases, when it leads to increased production, causes incomes of producers (wages and profits) to rise as well. These producers typically spend a large fraction of this increase in income on consumption, which is also a component of aggregate demand. Thus AD shifts to the right by not just the amount of the increased G, but also by the amount of the induced increase in C. And since each increase in C also causes a further increase in production, income, and therefore C, the multiplier effect includes a whole chain of increases in C as well as the increase in G.

The crowding-out effect, in contrast, works through the short-run money market, the interest rate, and investment. As income rises due to the increase in G (and induced increases in C), demand for money rises to finance these transactions. Assuming (as we do) that the central bank holds the money supply constant and also (since we are looking now at the horizontal shift of AD and thus at a fixed price level) that the price level also remains unchanged, this rise in demand for money will require a rise in the interest rate to clear the money market. The rise in the interest rate will in turn reduce investment, I, which is yet another component of AD. This is why the crowding-out effect acts to reduce the size of the horizontal shift of AD due to the increase in G.

Now here multiplier effect by which AD will shift is (1 / MPC ) * Change in G

= (1 / 0.8) * 9

= 11.25 billion

As crowding out effect is 25 billion .Hence AD curve will shift leftwards by (25-11.25 ) = 13.75 billion