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 160 LRAS AS 140 120 100 80 60 AD AD 1 40 20 0 80 160 240 320 400 480 560 640 720 800 Real GDP (billions of dollars) Price Level

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?

     $ ___________ billion

b. If the MPC is 0.75, 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 0.8.

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 $  billion and government purchases need to change by $ ___________ billion.

Answer 1

a) The Gap in the market is 80 billion so the aggregate demand need to increase by 80 billion to match the long run aggregate supply in the market.

b) Of the MPC is 0.75 then the multiplier will be 4 and the government need to increase its expenditure by 80/4 = 20 to match the equilibrium.

c) If the MPC is 0.8 then government need to increase the output by 80/5 = 16 as the multiplier will be 5. Answer is 16 billion.

MPC = 1/ 1-MPC.