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Question 1:

a) Identify the government purchases multiplier in these cases: MPC = .85

Multiplier = 1/(1 b )

MPC =b= 3/5

So multiplier = 1/ (1-3/5)= 2.5

If MPC= 0.85

So multiplier = 1/ (1-0.85) = 6.67

b) Identify the MPC if the multiplier is 2.5, 5

Multiplier = 1/(1 b )

2.5 = 1/(1-b)

b=mpc= 0.6

Multiplier = 1/(1 b )

5=1/(1-b)

mpc=b=0.8

Question 2:a) If the MPC is 0.80 and there are no crowding-out or accelerator effects, then an initial increase in

aggregate demand of $100 billion will eventually shift the aggregate demand curve to the right by

billion?

(Y = [ 1/(1 b )](AD

(Y = (1/(1-0.8))100

(Y = 500

So the aggregate demand curve would shift by $500billion.

b) Assume that the MPC is 0.75. Assuming that only the multiplier effect matters, a decrease in

government purchases of $10 billion will shift the aggregate demand curve to what direction? Calculate

the movement of AD (? billions).

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With a decrease in government purchases the aggregate demand curve would shift to the left as the

aggregate demand decreases with the decrease in the government expenditure. The change in

aggregate demand would be

(Y = [ 1/(1 b )](G

= (1/(1-0.75)) 10

=40 so the aggregate demand would decrease by $40 billion.

c) Assume that the MPC is 0.75. Assume that there is a multiplier effect and that the total crowding-out

effect is $6 billion. An increase in government purchases of $10 billion will shift aggregate demand to

what direction? Calculate the movement of AD (? billions).

As the government expenditure is increasing the aggregate demand would increase by

(Y = [ 1/(1 b )](G

= (1/(1-0.75)) 10

= 40

However due to crowding out the increase in aggregate demand would be reduced by $ 6 billion.

Therefore the movement of aggregate demand would be 40-6 = $34 billion.