Suppose the closed economy is in long-run equilibrium. Pessimism on the part of investors then shifts the aggregate-demand curve $50 billion to the left. The government wants to increase spending in order to avoid a recession. If the crowding-out effect is always half as strong as the multiplier effect, and if the MPC equals 0.9, by how much do government purchases have to rise?
A) $10 billion
B) $20 billion
C) $50 billion
D) $100 billion

Question

Quizplus · Accepted Answer

The crowding-out effect is half as strong as the multiplier effect, so the government spending multiplier is 2. The MPC is 0.9, so the government spending multiplier is 1/(1-MPC) = 1/(1-0.9) = 10. Therefore, government purchases have to rise by $50 billion * 10 = $500 billion.

Suppose the Closed Economy Is in Long-Run Equilibrium