If no fiscal policy changes are made, suppose the current aggregate demand curve will increase horizontally by $1,000 billion and cause inflation. If the marginal propensity to consume (MPC) is 0.80, federal policymakers could follow Keynesian economics and restrain inflation by decreasing:
A) government spending by $200 billion.
B) taxes by $100 billion.
C) taxes by $1,000 billion.
D) government spending by $1,000 billion.

Question

Quizplus · Accepted Answer

The question states that if no fiscal policy changes are made, aggregate demand would increase by $1,000 billion and cause inflation. To prevent this inflation, policymakers can use contractionary fiscal policy (decreasing government spending or increasing taxes).

The MPC is 0.80, which means that for every additional dollar of income, consumers will spend 80 cents and save 20 cents. Therefore, a $1,000 billion increase in aggregate demand would lead to an increase in consumer spending of 0.80 x $1,000 billion = $800 billion.

To counteract this increase in consumption, the government needs to decrease aggregate demand by $800 billion. Since the MPC is 0.80, a decrease in government spending by $200 billion (0.80 x $200 billion = $160 billion) would decrease consumption by $160 billion, which would lead to a decrease in aggregate demand of $800 billion.

Therefore, the best choice is A, which is to decrease government spending by $200 billion.

If No Fiscal Policy Changes Are Made, Suppose the Current