# Government purchases

Suppose that economists observe that in a closed economy an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.

* If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?

* Now suppose that the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

Suppose that the government of a closed economy reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4.

* What is the initial effect of the tax reduction on aggregate demand?

* What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand?

* How does the total effect of this $20 billion tax cut compare with the total effect of a $20 billion increase in government purchases? Why?

https://brainmass.com/economics/demand-supply/government-purchases-97296

#### Solution Preview

Hello!

Please find the solutions below.

1) Suppose that economists observe that in a closed economy an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.

* If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?

If there's no crowding out, then the multiplier equals 1/(1-MPC). Since the multiplier is 3, then MPC = 2/3.

* Now suppose that the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

If there's ...

#### Solution Summary

Effects on aggregate demand are implied.