Exhibit 15-7 Aggregate demand and supply model Suppose the economy in Exhibit 15-7 is in equilibrium at point E₁ and the marginal propensity to consumer ( MPC ) is 0.75. Following Keynesian economics, to lower the price level from 170 to 150, the government should reduce its spending by: A) $20 billion. B) $100 billion. C) $133 billion. D) $400 billion.

Question

Quizplus · Accepted Answer

According to Keynesian economics, reducing government spending will shift the aggregate demand curve to the left, causing a decrease in the price level. To lower the price level from 170 to 150, we need to move from point E₁ to a point on the aggregate demand curve where the price level is 150. This means we need to shift the aggregate demand curve leftward by an amount equal to the difference between output at E₁ and output at the new equilibrium point. From the graph, we can see that the output gap is about $100 billion when the price level is 170 and is about $20 billion when the price level is 150. Therefore, the government should reduce its spending by $100 billion - $20 billion = $80 billion. However, the question asks for the reduction in government spending needed to achieve a lower price level of 150, not the actual reduction in spending. Since the marginal propensity to consume is 0.75, a $1 reduction in government spending will reduce aggregate demand by $1 multiplied by the multiplier (1/0.25) = $4. Therefore, the government should reduce its spending by $80 billion divided by $4 = $20 billion. This is the closest choice available, so the answer is B.

Exhibit 15-7 Aggregate Demand and Supply Model Suppose the Economy