Initially, the economy is in long-run equilibrium. Aggregate demand then shifts leftward by $50 billion. The government wants to increase its spending in order to avoid a recession. If the crowding-out effect is always one-third as strong as the multiplier effect, and if the MPC equals 0.6, then by how much do government purchases have to increase in order to offset the $50 billion leftward shift?
A)By $90 billion
B)By $60 billion
C)By $20 billion
D)By $30 billion

Question

Quizplus · Accepted Answer

The multiplier effect is calculated as 1/(1-MPC), which equals 1/(1-0.6) = 2.5. If the crowding-out effect is one-third as strong, it reduces the multiplier effect to 2/3 of its original value, making the effective multiplier 2.5 * (2/3) = 5/3. To offset a $50 billion shift, we solve for X in the equation (5/3)X = $50 billion, giving X = $30 billion.

Initially, the Economy Is in Long-Run Equilibrium