Answer the following questions:
a. If aggregate expenditures falls by $5 million, and the MPC is 0.80, explain the process that will drive the economy to a new equilibrium level.
b. What will be the final result of this initial change?
a. The initial $5 million decrease in aggregate expenditures will cause real GDP to fall by $5 million. People will respond to this change by cutting consumption spending by $4 million (+$5 million × 0.80). This second decrease in aggregate expenditures will cause real GDP to fall by $4 million, triggering an additional $3.2 million (+$4 million × .80) decrease in consumption spending. This will cause successive cuts in income and consumption, each smaller than the previous one.
b. The spending multiplier in this case is 1/(1 ? 0.80) = 5 . This means that real GDP will fall by $5 for every $1 initial change in aggregate expenditures. Therefore, the cumulative effect is that real GDP will fall by $25 million (= $5 million × 5).
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