The Impact of Government Action on Aggregate Demand

What will happen if the government raises both taxes and spending by $100 million and the marginal propensity to consume is 0.8?

a. Aggregate demand will increase by $100 million.
b. Aggregate demand will decrease by $100 million.
c. Aggregate demand will increase by $80 million.
d. Aggregate demand will decrease by $80 million.

Final answer:

If the government simultaneously raises taxes and spending by $100 million with a marginal propensity to consume of 0.8, aggregate demand will increase by $100 million.

Your question pertains to the effects of government action on aggregate demand. Specifically, you're wondering what will happen if the government raises both taxes and spending by $100 million with a marginal propensity to consume (MPC) of 0.8. Given your scenario, the impact on aggregate demand depends on the multiplier, which is affected by the marginal propensity to consume. The MPC at 0.8 implies that 80% of the increased income from spending will be consumed while the rest will be saved. The multiplier formula is 1/(1-MPC), which in this case would result in a multiplier of 5. This means each dollar of spending will generate $5 of aggregate demand. Hence, an increase in spending of $100 million would increase demand by $500 million. However, the tax increase also removes disposable income, reducing consumption. Like spending, taxes create a knockout effect on the MPC resulting in a decrease in demand. Here the tax multiplier (which is negative) is -MPC/ (1-MPC), so -0.8/(1-0.8) = -4. Consequently, the tax rise would decrease aggregate demand by $400 million. In conclusion, following this simultaneous raise in spending and taxes, aggregate demand would rise by $100 million ($500m gain from spending minus the $400m loss from taxes). Therefore, option 1, 'Aggregate demand will increase by $100 million', is correct.