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 increasing government purchases to reduce the burden of this recession. Fiscal Policy LRAS Price Level 80 160 240 320 400 480 560 640 720 800 Real GDP (billions of dollars) Instructions: Enter your answers as a whole number. 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 0.6, how much does government purchases need to change to shift aggregate demand by the amount you found in part a? $ [ billion Suppose instead that the MPC is 0.75. c. How much does aggregate demand and government purchases need to change to restore the economy to its long-run equilibrium? Aggregate demand needs to change by $ O b illion and government purchases need to change by $ O b illion.

Answer 1

a) Keeping in mind that price level will absorb some of the change in AD, the aggregate demand is required to increase by (400 - 240) = $160 billion

b) MPC is 0.6 so MPS is 1-0.6 = 0.4. Spending multiplier is 1/0.4 = 2.5 so government spending should increase by 160/2.5 = $64 billion

c) Aggregate demand should increase by $160 billion. But now spending multiplier is 1/0.25 = 4. So government spending should increase by 160/4 = $40 billion