Question

part 1a. Which of the following events will lead to an increase in aggregate demand?

	a.	an increase in interest rates.
	b.	an increase in income inequality.
	c.	an increase in import spending.
	d.	an increase in capacity utlization.
	e.	none of the above

1b:

1. In the fixed-price Keynesian model, which of the following will lead to the largest increase in real GDP?

   	a.	a balanced budget change of $500.
   	b.	an increase in government spending of $500.
   	c.	a decrease in government spending of $500.
   	d.	a decrease in taxes of $500
   	e.	an increase in taxes of $500.

Answer 1

1a)

a. an increase in interest rates will drive down the investment demand and hence the aggregate demand will decrease.

b. an increase in income inequalities might not necessarily lead to an increase in the aggregate demand as the relative purchasing power of a large section of consumers would be lesser.

c. an increase in import spending will lead to a decrease in the net exports and hence the aggregate demand will decrease

d. an increase in capacity utilization would increase the aggregate income which in turn increases the aggregate demand in the economy.

Ans: d. an increase in capacity utilization

1b)

Government spending multiplier = 1/(1-MPC) where MPC = Marginal propensity to consume

Tax cut multiplier = MPC/(1-MPC)

Tax-cut multiplier is less than the government spending multiplier as the value of MPC is less than 1.

Moreover, an increase in government spending by running a budget deficit increases the real GDP compared to a balanced budget scenario.

Real GDP increases when the government spending increases or taxes decrease.

Ans: b. an increase in government spending of $500