If no fiscal policy changes are implemented to fight inflation, suppose the aggregate demand curve will exceed the current aggregate demand curve by $900 billion at any level of prices. Assuming the marginal propensity to consume is 0.90, this increase in aggregate demand could be prevented by:
A) increasing government spending by $500 billion.
B) increasing government spending by $140 billion.
C) decreasing taxes by $40 billion.
D) increasing taxes by $100 billion.

Question

Quizplus · Accepted Answer

To prevent the increase in aggregate demand, we need to decrease disposable income, which can be achieved by increasing taxes. Using the formula: ∆Y = (∆A)/ (1-MPC), we can find the change in output or income (∆Y) by a change in aggregate demand (∆A) when the MPC is known. Solving for ∆A, we get: ∆A = (∆Y) x (1-MPC)/(MPC). Substituting the given values, we get  ∆A = $900 billion, MPC = 0.90. Solving, we get  ∆Y = ∆A x MPC/ (1-MPC) = $9 billion. To prevent this increase in income, we need to decrease aggregate demand by $900 billion, which can be achieved by increasing taxes by $100 billion (assuming a multiplier of 9). Therefore, option D is the best choice.

If No Fiscal Policy Changes Are Implemented to Fight Inflation