Question

The graph below depicts an economy where a decline in aggregate demand has caused a recession. Assume the government decides to conduct fiscal policy by changing taxes to reduce the burden of this recession. Fiscal Policy 150 LRAS Price Level 0 80 160 240 320 400 480 560 640 720 800 Real GDP (billions of dollars) Instructions: Enter your answers as a whole number. If you are entering any negative numbers be sure to include a negative sign (-) in front of those numbers. a. How much does aggregate demand need to change to restore the economy to its long-run equilibrium? $ O billion b. If the MPC is 0.5, how much do taxes need to change to shift aggregate demand by the amount you found in part a? $ billion Suppose instead that the MPC is 0.8. c. How much does aggregate demand and taxes need to change to restore the economy to its long-run equilibrium? Aggregate demand needs to change by $ O b illion and taxes need to change by $ O b illion.

Answer 1

A.

Change in aggregate demand = 400-280

Change in aggregate demand = $120 Billion

-----

B.

There will be decrease in tax.

Taxation multiplier = -MPC/(1-MPC) = -.5/(1-.5) = -1

So,

decrease in taxes = 120/taxation multiplier = 120/1

decrease in taxes = $120 Billion

--------------

IF MPC = .8

Then,

Taxation multiplier = -MPC/(1-MPC) = -.8/(1-.8) = -4

decrease in taxes = 120/taxation multiplier = 120/4

decrease in taxes = $30 Billion

C.

Suppose instead that the MPC is 0.8. c. How much does aggregate demand and taxes need to change to restore the economy to its long-run equilibrium? Aggregate demand needs to change by $ 120 billion and taxes need to change by $ 30 billion. (decrease)