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Chapter 21: Q 7. (page 566)

Why does equilibrium output increase as the marginal propensity to consume increases?

Short Answer

Expert verified

Increase in Marginal Propensity to consume leads to higher consumption levels, & latter is a part of Aggregate Demand. Rise in AD increases equilibrium output.

Step by step solution

01

Step 1. Introduction

Marginal Propensity to consume denotes the proportion of additional income spent on consumption, as a ratio of change in consumption to change in expenditure.

Aggregate Demand is the total amount of expenditure, all sectors of economy are planning to incur during a period of time. It comprises of households' consumption expenditure.

Equilibrium is determined where Aggregate Demand = Aggregate Supply

02

Detail Explanation 

Increase in Marginal propensity to consume increases the consumption expenditure, rotates the consumption & consequently the AD curve upwards.

Higher level of Aggregate Demand implies that Aggregate Demand & Aggregate Supply are equal at a higher level of output & income. Hence, the equilibrium output increases.

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Most popular questions from this chapter

鈥淲hen the stock market rises, investment spending is increasing.鈥� Is this statement true, false, or uncertain? Explain your answer.

When the Federal Reserve reduces its policy interest rate, how, if at all, is the IS curve affected? Briefly explain.

In each of the following cases, determine whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift.

a. The real interest rate rises.

b. The marginal propensity to consume declines.

c. Financial frictions increase.

d. Autonomous consumption decreases.

e. Both taxes and government spending decrease by the same amount.

f. The sensitivity of net exports to changes in the real interest rate decreases.

g. The government provides tax incentives for research and development programs for firms.

If the consumption function is C = 100 + 0.75YD, I = 200, government spending is 200, and net exports are zero, what will be the equilibrium level of output?

What will happen to aggregate output if government spending rises by 100?

Consider an economy described by the following data:

C=\(3.25trillionI=\)1.3trillionG=\(3.5trillionT=\)3.0trillionNX=-\(1.0trillionf=1

mpc = 0.75

d = 0.3

x = 0.1

a. Derive simplified expressions for the consumption function, the investment function, and the net export function.

b. Derive an expression for the IS curve.

c. If the real interest rate is r = 2, what is equilibrium output? If r = 5, what is equilibrium output?

d. Draw a graph of the IS curve showing the answers from part (c) above.

e. If government purchases increase to \)4.2 trillion, what will happen to equilibrium output at r = 2? What will happen to equilibrium output at r = 5? Show the effect of the increase in government purchases in your graph from part (d).
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