Exhibit 16A-3 Macro AD/AS Model

As shown in Exhibit 16A-3, assume the marginal propensity to consume MPC equals 0.80. Using discretionary fiscal policy, federal government spending should be _________ in order to restore the economy from E ₁ to full employment.

Question

Exhibit 16A-3 Macro AD/AS Model
Exhibit 16A-3 Macro AD/AS Model As shown in Exhibit 16A-3, assume the marginal propensity to consume MPC equals 0.80. Using discretionary fiscal policy, federal government spending should be _________ in order to restore the economy from E <sub> 1 </sub> to full employment. A) increased by $2 trillion B) decreased by $2 trillion C) decreased by $.40 trillion D) increased by $.80 trillion

Exhibit 16A-3 Macro AD/AS Model As shown in Exhibit 16A-3, assume the marginal propensity to consume MPC equals 0.80. Using discretionary fiscal policy, federal government spending should be _________ in order to restore the economy from E <sub> 1 </sub> to full employment. A) increased by $2 trillion B) decreased by $2 trillion C) decreased by $.40 trillion D) increased by $.80 trillion

As shown in Exhibit 16A-3, assume the marginal propensity to consume MPC equals 0.80. Using discretionary fiscal policy, federal government spending should be _________ in order to restore the economy from E ₁ to full employment.

Quizplus · Accepted Answer

To restore the economy to full employment, we need to increase aggregate demand (AD) which can be achieved by increasing government spending. The MPC measures the marginal propensity to consume, or in other words, how much of each additional dollar of income is spent. A higher MPC indicates that more of the additional income will be spent, leading to a larger multiplier effect and a greater increase in AD. Since MPC is 0.80, each additional dollar of government spending will increase AD by $4 (1/1-0.8). Therefore, to increase AD by $500 billion (the difference between S1U1B0 and S1), government spending should be increased by $125 billion (0.8 x $125 billion = $100 billion increase in consumption, and $100 billion x 4 = $400 billion increase in AD). This is equivalent to an increase of $0.80 trillion, which is option D.