The economy is in long-run equilibrium.The aggregate demand curve shifts $80 billion to the left.The government wants to change spending to offset this decrease in demand.The MPC is .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.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 .75, so a $1 change in government spending will lead to a $0.75 change in aggregate demand. A $1 change in taxes will lead to a $0.25 change in aggregate demand. Therefore, to offset the $80 billion decrease in aggregate demand, the government needs to increase spending by $80 billion and increase taxes by $80 billion.

The Economy Is in Long-Run Equilibrium