Question

suppose the government increases spending on highway construction by $5 billion. Which way does the AD curve shift? explain why the shift might be larger than $5 billion and why the shift might be smaller than $10 billion.

Answer 1

the increase in government spending increases AD as the government spending positively related to AD. it shifts the AD curve to the right.

It increases AD more than the initial change in spending because there is a spilover effect of the spending as the government spending is an income of someone and then the consumption and investment spending increases and that increases AD more than $5 billion

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the spillover effect depends on the economic drain and the marginal propensity to consume. If the MPC is lower then the AD increases less than the relatively higher MPC.

Suppose MPC=0.4

Multiplier =1/(1-MPC)=1/(1-0.4)=1.66666667

then

change in AD=intial change in spending * multiplier

=5*1.66666667

=8.33333335 billion

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and if the MPC=0.6 then Multiplier =1/(1-0.6)=2.5

change in AD=5*2.5=12.5 billion

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so the change in AD is higher than $5 billion but it may be less than $10 billion if tthe MPC is lower than 0.5.