Question

1) An economy is currently producing at an equilibrium level of real GDP of $14 trillion. What will happen if government spending (alone, with no other changes) decreases by $100 billion? Will real GDP increase or decrease? Explain why it will change by $100 billion, by less, or by more.

2)Explain why rising prices reduce the spending multiplier effect of an increase in aggregate demand.

Answer 1

If government spending is reduced by hundred billion, then initially the aggregate demand and the real GDP both are reduced by hundred billion. But then there is a multiplier effect. When the real GDP is decreased, it also decreases the consumption which is a part of aggregate demand. therefore in the next round aggregate demand decreases by 100 * MPC because for everyone dollar change in income consumption changes by 1*MPC. Therefore in each subsequent round this decreases the real income by the multiplier. Multiplier in this case is the reciprocal of marginal propensity to save. Thus, in the end real GDP will actually decrease buy more than hundred billion due to multiplier effect.

When there are increasing prices in the multiplier effect is reduced because we assume that consumers will change the consumption considering prices to be constant. but prices are also increasing in the short run with indicates that consumption does not increase as much as we believe and therefore aggregate demand does not increase as much. This indicates that rising prices undermine the multiplier effect.