Suppose inflation is a threat because the current aggregate demand curve will increase by $600 billion at any price level. If the marginal propensity to consume is 0.75, federal policymakers can follow Keynesian economics and restrain inflation by:
A) decreasing tax revenues by $600 billion.
B) decreasing government spending by $200 billion.
C) increasing tax revenues by $200 billion.
D) increasing government purchases by $150 billion.

Question

Quizplus · Accepted Answer

To restrain inflation, policymakers need to decrease aggregate demand. With a marginal propensity to consume of 0.75, the multiplier is 1/(1-0.75) = 4. To offset a $600 billion increase in demand, they need to reduce demand by $600 billion / 4 = $150 billion. Increasing tax revenues by $200 billion will reduce disposable income and consumption by $150 billion, thus reducing aggregate demand by the required amount.

Suppose Inflation Is a Threat Because the Current Aggregate Demand