Question 70

The $200 billion tax cut with an MPC of 0.8 increases AD by up to $800 billion.

A $200 billion tax cut, combined with a marginal propensity to consume (MPC) of 0.8, leads to an increase in aggregate demand (AD) of up to $800 billion due to the multiplier effect.

A) $160 bn

This option is incorrect because it underestimates the impact of the tax cut and the MPC. With an MPC of 0.8, the initial $200 billion would create a larger multiplier effect, which is calculated as $200 billion times the multiplier (which is 1/(1-MPC) = 5). Thus, $200 billion leads to a total increase in AD well beyond $160 billion.

B) $200 bn

Option B misrepresents the potential increase in aggregate demand by suggesting it equals the amount of the tax cut directly. While the initial tax cut is indeed $200 billion, the multiplier effect from the MPC of 0.8 indicates that the total increase in AD will be significantly larger than the initial amount.

C) $800 bn

This option is correct as it reflects the total increase in aggregate demand resulting from the $200 billion tax cut and an MPC of 0.8. The multiplier effect, calculated as 1/(1-0.8), equals 5, which means the total increase in AD is $200 billion multiplied by 5, resulting in $800 billion.

D) $1,000 bn

Option D is incorrect because it overestimates the impact of the tax cut. While the multiplier effect does suggest a significant increase in AD, the correct calculation based on the provided MPC leads to an increase of only $800 billion, not $1,000 billion.

Conclusion

The correct answer, $800 billion, is derived from applying the multiplier effect to the $200 billion tax cut with an MPC of 0.8. All other options fail to accurately represent the economic principles at play, either underestimating or overestimating the increase in aggregate demand. Thus, $800 billion stands as the definitive correct response based on the given context.