Question

(Advanced analysis) Assume that the MPC is .8 in an economy that has an aggregate supply curve with a slope of 1. Also, suppose that the price level is flexible downward. A decrease in investment spending of $10 billion will shift the aggregate demand curve leftward by:

A) $50 billion and decrease real GDP by $50 billion.
B) $50 billion and decrease real GDP by $25 billion.
C) $10 billion and decrease real GDP by $10 billion.
D) $10 billion and decrease real GDP by $25 billion.

Answer 1

A decrease in investment spending of $10 billion will shift the aggregate demand curve leftward by $50 billion and decrease real GDP by $50 billion.

Step-by-step explanation:

In this scenario, we are given that the MPC (marginal propensity to consume) is 0.8 and the aggregate supply curve has a slope of 1. Assuming price level flexibility, a decrease in investment spending of $10 billion will shift the aggregate demand curve leftward. To determine the magnitude of this shift, we can use the multiplier formula:

MPC = 1 / (1 - MPC)

Plugging in the given value for MPC, we get: 0.8 = 1 / (1 - 0.8).

Solving for (1 - MPC), we find: (1 - 0.8) = 0.2.

Now, we can calculate the magnitude of the shift in aggregate demand:

Shift in aggregate demand = (Change in investment spending) * (Multiplier)

= (-$10 billion) * (1 / (1 - 0.8))

= (-$10 billion) * (1 / 0.2)

= - $50 billion.

Therefore, the correct answer is A) $50 billion and decrease real GDP by $50 billion.