Question

In 2009 President Obama and Congress increased government spending. Some economists thought this increase would have little effect on output. Which of the following would make the effect of an increase in government expenditures on aggregate demand smaller?
a.
the MPC is small and changes in the interest rate have a small effect on investment

b.
the MPC is small and changes in the interest rate have a large effect on investment

c.
the MPC is large and changes in the interest rate have a small effect on investment

d.
the MPC is large and changes in the interest rate have a large effect on investment

Answer 1

Answer:

The correct answer is option b.

Explanation:

An increase in government expenditure will have a smaller effect on the aggregate demand if the MPC is smaller. This happens because the consumers will save the major share of their income and not consume it if MPC is small.  

This will not increase consumer spending as much as they should. And thus aggregate demand will increase by a small amount.  

The change in aggregate demand will also be smaller if the investment is interest elastic. The government increases spending by borrowing from the loanable funds market.  

This increases the demand for loanable funds. The interest rate, as a result, increases. This increase in interest rate makes borrowing costlier for private investors.  

This further causes the investment expenditure to increase as much as it should. And thus aggregate demand will increase by a small amount as well.