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?

Select one:

1. It will shift the AD curve right by $20 billion.

2. It will shift the AD curve left by $25 billion.

3. It will shift the AD curve right by $25 billion.

4. It will shift the AD curve left by $20 billion.

Answer 1

When government faces budget deficit due to higher government expenditure for increasing aggregate demand, then for financing these deficits, government borrow from loanable fund market. As a result, demand for loanable fund increases, so demand curve shifts rightward. Hence real interest rate increases. At higher interest rate private investment spending decrease. So the extra government expenditure done by the government diminishes for increasing aggregate demand. This is known as the crowding out.

The given crowding out is $25 billion.

MPC=0.8

MPS=1-MPC

=1-0.8

=0.2

Spending multiplier=1/MPS

=1/0.2

=5

Since government increases its spending by $9 billion.

The total increase in the AD= change in the government spending* spending multiplier

=9*5

=$45 billion

But there is crowding out of $25 billion. It means actual rightward shift of the AD will be

= total increase in the AD – crowding out

=45-25

=$20 billion

Hence option 1 is the correct answer.