Suppose that the economy is operating in full-employment equilibrium along the vertical section of the aggregate supply curve. If the aggregate demand curve is reduced by $100 billion in order for the price level to decline by 5 percent, and if the marginal propensity to consume (MPC) is 0.75, then what change in taxes would generate the desired price reduction?
A) $300 billion.
B) − $75 billion.
C) − $33.3 billion.
D) − $25 billion.

Question

Quizplus · Accepted Answer

Since the economy is operating at full-employment equilibrium along the vertical section of the aggregate supply curve, output is fixed and any changes in demand will only affect the price level. Therefore, a decrease in aggregate demand by $100 billion will result in a 5% decrease in the price level.

The MPC of 0.75 indicates that for every $1 decrease in taxes, consumption spending will increase by $0.75. To achieve the desired $100 billion decrease in aggregate demand, we need to use the following formula:

Change in Taxes = (Desired Change in Aggregate Demand) / MPC

= $100 billion / 0.75

= $133.3 billion

However, we are looking for the change in taxes needed to achieve a 5% decrease in the price level, which is smaller than the desired $100 billion decrease in aggregate demand. This means that we need a smaller change in taxes than the calculated $133.3 billion.

To find the exact change in taxes needed, we can use the following formula:

Change in Price Level = (Change in Aggregate Demand / Aggregate Demand) x (1 / Marginal Propensity to Consume)

-5% = (-$100 billion / Aggregate Demand) x (1 / 0.75)

Aggregate Demand = $2 trillion

The initial level of aggregate demand is $2 trillion, and we need to decrease it by $100 billion to achieve the desired 5% decrease in the price level. Therefore, the new level of aggregate demand is $1.9 trillion.

To find the change in taxes needed, we can use the formula:

Change in Taxes = (Change in Aggregate Demand) / MPC

= ($1.9 trillion - $2 trillion) / 0.75

= -$133.3 billion / 0.75

= -$177.3 billion

However, this answer is in terms of a decrease in taxes, and we are looking for the absolute value of the change in taxes. Therefore, the answer is:

Answer: C

The change in taxes needed to achieve the desired 5% decrease in the price level is -$33.3 billion.

Suppose That the Economy Is Operating in Full-Employment Equilibrium Along