When economy below full employment, fiscal action to restore equilibrium:

Rationale

$100 bn

When the marginal propensity to consume (MPC) is 0.9, government spending can lead to a multiplied effect on aggregate demand (AD). The formula for the change in AD resulting from government spending is given by the spending multiplier, which is calculated as 1/(1-MPC). In this case, the multiplier is 10, resulting in a maximum change in AD of $100 billion when $10 billion is spent.

A (raise taxes) YOUR ANSWER

This choice incorrectly applies the multiplier effect, as it suggests a minimal change in aggregate demand. With an MPC of 0.9, the spending multiplier is 10; thus, the expected change in AD should be much higher than $9 billion.

B (cut spending) YOUR ANSWER

While this option reflects the initial government spending, it fails to account for the multiplier effect. Government spending of $10 billion results in a total change in AD of $100 billion when considering the MPC of 0.9, not just the amount spent.

C (raise reserve ratio) YOUR ANSWER

This choice mistakenly calculates the change in aggregate demand, suggesting a change just below the maximum potential. While $90 billion might seem plausible, the correct calculation reveals that the total change in AD is indeed $100 billion, reflecting the full effect of the spending multiplier.

D (increase government spending) CORRECT

This option accurately reflects the maximum change in aggregate demand when MPC is 0.9. The spending multiplier of 10 applied to the initial $10 billion in government spending results in a total increase in AD of $100 billion, demonstrating the powerful impact of fiscal policy.

Conclusion

Understanding the relationship between government spending and aggregate demand is crucial in economics. With an MPC of 0.9, the spending multiplier indicates that for every dollar spent by the government, the total increase in aggregate demand is tenfold, leading to a maximum change of $100 billion from an initial $10 billion in spending. This reflects the potency of fiscal stimuli in influencing economic activity.

When economy below full employment, fiscal action to restore equilibrium:

$100 bn

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