Initially,the economy is in long-run equilibrium.The aggregate demand curve then shifts $80 billion to the left.The government wants to change spending to offset this decrease in demand.The MPC is 0.75.Suppose the effect on aggregate demand of a tax change is 3/4 as strong as the effect of a change in government expenditure.There is no crowding out and no accelerator effect.What should the government do if it wants to offset the decrease in real GDP?
A)Raise both taxes and expenditures by $80 billion dollars.
B)Raise both taxes and expenditures by $10 billion dollars.
C)Reduce both taxes and expenditures by $80 billion dollars.
D)Reduce both taxes and expenditures by $10 billion dollars.

Question

Quizplus · Accepted Answer

The government should raise both taxes and expenditures by $80 billion to offset the decrease in real GDP. This is because the MPC is 0.75, so a $1 change in government spending will lead to a $0.75 change in aggregate demand. Therefore, to offset the $80 billion decrease in aggregate demand, the government needs to increase spending by $80 billion / 0.75 = $106.67 billion. However, since the effect of a tax change is 3/4 as strong as the effect of a change in government expenditure, the government can also offset the decrease in aggregate demand by raising taxes by $80 billion / (0.75 * 3/4) = $142.86 billion.

Initially,the Economy Is in Long-Run Equilibrium