Question 43

The maximum change in aggregate demand (AD) is $100 billion when the marginal propensity to consume (MPC) is 0.9.

When the MPC is 0.9, the spending multiplier can be calculated as 1 / (1 - MPC), which results in a multiplier of 10. Therefore, with $10 billion in government spending, the maximum change in aggregate demand is $10 billion multiplied by the multiplier of 10, equating to $100 billion.

A) $9 bn

This option is incorrect because it significantly underestimates the effect of the government spending when considering the multiplier. With an MPC of 0.9, the proper calculation leads to a much larger change in aggregate demand.

B) $10 bn

This option is also incorrect as it only accounts for the initial government spending without considering the multiplier effect. The calculation should reflect the total impact of the spending, which is considerably higher due to the MPC.

C) $90 bn

While this option is closer to the correct calculation, it still fails to account for the full effect of the multiplier based on the given MPC. The actual maximum change in aggregate demand is derived from the correct application of the spending multiplier.

D) $100 bn

This option is correct because it accurately reflects the maximum change in aggregate demand when applying the multiplier formula. With an MPC of 0.9, the multiplier is 10, resulting in a total change of $100 billion from $10 billion in government spending.

Conclusion

The correct answer is $100 billion, as it properly incorporates the effect of the spending multiplier associated with an MPC of 0.9. All other options fail to represent the total impact of government spending on aggregate demand, either by not applying the multiplier correctly or by misunderstanding the relationship between government spending and its effect on AD.