Briefly explain how reductions in government purchases and tax decreases would influence aggregate demand through the multiplier effect. Give an example.

Question

What will be an ideal response?

Answer 1

Student examples will vary. A sample answer follows: Reductions in government purchases and tax increases are magnified by the multiplier effect. Suppose the government made cutbacks in highway building. Not only would it decrease government purchases directly, but construction workers would be laid off and unemployed workers would cut back on their consumption spending; this initial cutback would have a multiplying effect through the economy, leading to an even greater reduction in aggregate demand. Similarly, tax hikes would leave consumers with less disposable income, so they would cut back on their consumption, which would lower aggregate demand and set off the multiplier process, leading to an even larger cumulative effect on aggregate demand.