Question

The government spends $3 billion to buy police cars. Explain why aggregate demand might increase by more than $3 billion. Explain why aggregate demand might increase by less than $3 billion.

Answer 1

When the government spends $3 billion to buy police cars, aggregate demand can increase by more or less than $3 billion due to multiplier effects and leakages in the economy.

Step-by-step explanation:

When the government spends $3 billion to buy police cars, aggregate demand might increase by more than $3 billion because the initial investment can have a multiplier effect on the economy. For example, when the government purchases the cars, it pays the car manufacturer, who in turn may use the money to pay its employees or invest in other businesses. This increased spending can lead to a chain of increased income and consumption, resulting in a larger increase in aggregate demand.

On the other hand, aggregate demand might increase by less than $3 billion due to leakages in the economy. Leakages occur when not all of the money spent by the government is circulated back into the economy. For instance, some individuals might decide to save the extra income instead of spending it, which reduces the impact on aggregate demand. Taxes and imports can also act as leakages by reducing the amount of money available for consumption or investment.

Answer 2

When the government spends $3 billion on police cars, that purchase has repercussion. The impact of the higher demand from the government is to raise employment and profits at the firm that produce. Then, as the workers see higher earnings, the firm owners see higher profits, To increase in income by raising their own spending on goods. As a result, the government raises the demand for the products of many other firms in the economy.