Final answer:
When the government raises both taxes and spending by $100 million, the increase in government spending will have a multiplier effect on the economy. The correct answer to the question is C.
Step-by-step explanation:
The correct answer to the question is C. Aggregate demand will increase, and real GDP will increase by a maximum of $100.
When the government raises both taxes and spending by $100 million, the increase in government spending will have a multiplier effect on the economy. The multiplier effect is the idea that an initial increase in spending leads to a larger increase in aggregate demand and real GDP.
In this case, the multiplier effect is determined by the marginal propensity to consume, which is 0.8. This means that for every additional dollar of income, individuals will spend 80 cents.
Using the multiplier formula, we can calculate the impact on aggregate demand and real GDP. The formula is:
Multiplier = 1 / (1 - Marginal Propensity to Consume)
Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5
Therefore, a $100 million increase in government spending will lead to a 5 times larger increase in aggregate demand and real GDP. This translates to a maximum increase of $500 million.
However, since the question specifies that the increase in government spending is $100 million, the maximum increase in aggregate demand and real GDP will be $100 million.
The aggregate demand and real GDP will increase by a maximum of $500 million due to the multiplier effect when government raises both taxes and spending by $100 million with a marginal propensity to consume of 0.8.
When the government raises both taxes and spending by $100 million and the marginal propensity to consume is 0.8, the multiplier effect comes into play. This effect suggests that any initial increase in spending will cycle through the economy multiple times, having a greater impact on the aggregate expenditure and real GDP than the initial amount spent. Given a marginal propensity to consume of 0.8, the multiplier can be calculated as 1/(1 - 0.8) = 5. Thus, the increase in aggregate demand and real GDP will be the government spending increase of $100 million multiplied by the multiplier of 5, resulting in a maximum increase of $500 million in real GDP.
Therefore, the correct answer to the student's question is: E. Aggregate demand will increase, and real GDP will increase by a maximum of $500.