Exhibit 20A-4 Macro AD/AS Model

-As shown in Exhibit 20A-4,assume the marginal propensity to consume MPC equals 0.75.Using discretionary fiscal policy,federal government spending should be ____ in order to restore the economy from E₁ to full employment.
A) increased by $.25 trillion
B) decreased by $.25 trillion
C) decreased by $2 trillion
D) increased by $2 trillion
E) increased by $1 trillion

Question

Exhibit 20A-4 Macro AD/AS Model
 
-As shown in Exhibit 20A-4,assume the marginal propensity to consume MPC equals 0.75.Using discretionary fiscal policy,federal government spending should be ____ in order to restore the economy from E₁ to full employment.
A) increased by $.25 trillion 
B) decreased by $.25 trillion 
C) decreased by $2 trillion 
D) increased by $2 trillion 
E) increased by $1 trillion

Quizplus · Accepted Answer

According to the AD/AS model, increasing government spending will shift the aggregate demand (AD) curve to the right, resulting in higher GDP and higher price levels. To restore the economy to full employment, we need to shift the AD curve to the right until it intersects the long-run aggregate supply (LRAS) curve at potential GDP. Since the MPC is 0.75, an increase in government spending of $2 trillion would increase consumption by 0.75 x $2 trillion = $1.5 trillion, leading to a total increase in GDP of $6 trillion (= $1.5 trillion / (1 - 0.25)), assuming a tax rate of 25%. This increase in GDP would close the output gap and restore the economy to full employment. Therefore, the correct answer is D.