Initially,the economy is in long-run equilibrium.The aggregate demand curve then shifts $50 billion to the left.The government wants to change its spending to offset this decrease in demand.The MPC is 0.80.Suppose the effect on aggregate demand from a change in taxes is 4/5 the size of the change from government expenditures.There is no crowding out and no accelerator effect.What should the government do if it wants to offset the decrease in aggregate demand?
A)Raise both taxes and expenditures by $5.56 billion dollars.
B)Raise taxes by $40 billion dollars and increase expenditures by $50 billion dollars.
C)Reduce taxes by $10 billion dollars and increase expenditures by $10 billion dollars.
D)Reduce taxes by $5.56 billion dollars and increase expenditures by $5.56 billion dollars.

Question

Quizplus · Accepted Answer

The government should reduce taxes by $5.56 billion and increase expenditures by $5.56 billion to offset the decrease in aggregate demand. This is because the MPC is 0.80, so a $1 change in government spending will lead to a $0.80 change in aggregate demand. A $1 change in taxes will lead to a $0.40 change in aggregate demand. Therefore, the government needs to reduce taxes by $5.56 billion and increase expenditures by $5.56 billion to offset the $50 billion decrease in aggregate demand.

Initially,the Economy Is in Long-Run Equilibrium