Calculate the Increase in Aggregate Demand (AD) with Government Spending Increase

What is the formula to calculate the increase in Aggregate Demand (AD) when the government increases spending?

Options:

A. Increase in AD = Government Spending * (1 / MPC)
B. Increase in AD = Government Spending * (1 / (1 - MPC))
C. Increase in AD = Government Spending * MPC

Answer:

The correct formula to calculate the increase in Aggregate Demand (AD) when the government increases spending is B. Increase in AD = Government Spending * (1 / (1 - MPC)).

When the government increases spending, it affects the Aggregate Demand (AD) in the economy. The increase in government spending leads to a multiplier effect on the overall AD, which is determined by the Marginal Propensity to Consume (MPC).

The formula to calculate the increase in AD is: Increase in AD = Government Spending * (1 / (1 - MPC)). This formula takes into account the MPC, which represents the proportion of additional income that individuals spend on consumption.

In this case, if the government increases spending by $50 million and the given MPC is 0.8, we can calculate the increase in AD as follows:

Increase in AD = $50 million * (1 / (1 - 0.8))
Calculating the denominator: 1 - 0.8 = 0.2
Calculating the fraction: 1 / 0.2 = 5
Therefore, the increase in AD is: AD increases by $250 million.