Suppose every household decreases its consumption by 10% and consumption is roughly 70% of total output. A 10% decrease in consumption represents a 7% decrease in output. Aggregate demand will:Multiple choice question.decrease by less than 7% because of the expenditures multiplier.decrease by 7% because consumption is the largest component of aggregate demand.increase eventually because of the expenditures multiplier.decrease by more than 7% because of the expenditures multiplier.
Question
Suppose every household decreases its consumption by 10% and consumption is roughly 70% of total output. A 10% decrease in consumption represents a 7% decrease in output. Aggregate demand will:Multiple choice question.decrease by less than 7% because of the expenditures multiplier.decrease by 7% because consumption is the largest component of aggregate demand.increase eventually because of the expenditures multiplier.decrease by more than 7% because of the expenditures multiplier.
Solution
The correct answer is: decrease by more than 7% because of the expenditures multiplier.
Here's why:
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The question states that consumption is roughly 70% of total output. So, a 10% decrease in consumption would directly lead to a 7% decrease in output (because 10% of 70% is 7%).
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However, this is not the end of the story. The decrease in consumption will have a multiplier effect on the economy. This is because one person's spending is another person's income. So, a decrease in consumption means a decrease in income for others, which in turn leads to a further decrease in consumption.
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This multiplier effect means that the total decrease in aggregate demand will be more than the initial 7%. Therefore, the correct answer is that aggregate demand will decrease by more than 7% because of the expenditures multiplier.
Similar Questions
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A change in aggregate demand equals the multiplier times the initial change in expenditures.
Households' consumption function is: C=100+0.7YHouseholds are more pessimistic about the future and they decide to reduce their consumption by 10 units.What is the intercept of the consumption function now?
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