Assume that planned aggregate expenditure is given by the equation: PAE = 150 + 0.5Y. What is the effect of a 5 unit increase in government expenditure on short-run equilibrium output?Group of answer choicesOutput increases by 10 unitsOutput increases by 5 unitsOutput increases by 0.5 unitsNo change in short-run equilibrium output
Question
Assume that planned aggregate expenditure is given by the equation: PAE = 150 + 0.5Y. What is the effect of a 5 unit increase in government expenditure on short-run equilibrium output?Group of answer choicesOutput increases by 10 unitsOutput increases by 5 unitsOutput increases by 0.5 unitsNo change in short-run equilibrium output
Solution
The correct answer is: "Output increases by 10 units"
Here's a step-by-step explanation:
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The equation PAE = 150 + 0.5Y represents planned aggregate expenditure, where PAE is the sum of consumption, investment, government spending, and net exports, and Y is income or output.
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The coefficient 0.5 is the marginal propensity to consume (MPC), which is the change in consumption resulting from a change in income.
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In the Keynesian cross model, an increase in government spending shifts the PAE curve upward, leading to a higher level of equilibrium output.
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The multiplier effect in this case is 1/(1-MPC) = 1/(1-0.5) = 2. This means that a one unit increase in government spending leads to a two unit increase in output.
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Therefore, a 5 unit increase in government spending would lead to a 5 * 2 = 10 unit increase in output.
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Therefore, the correct answer is: "Output increases by 10 units".
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