Exhibit 20A-4 Macro AD/AS Model As shown in Exhibit 20A-4, assume the marginal propensity to consume MPC equals 0.75. Using discretionary fiscal policy, federal government spending should be ____ in order to restore the economy from E₁ to full employment. A) increased by $.25 trillion B) decreased by $.25 trillion C) decreased by $2 trillion D) increased by $2 trillion E) increased by $1 trillion

Question

Quizplus · Accepted Answer

Based on the information given, the economy is currently in a recessionary gap (E₁) and needs to be restored to full employment. This can be achieved using discretionary fiscal policy, which involves changing government spending and/or taxes to influence aggregate demand. The MPC (marginal propensity to consume) is 0.75, meaning that for every additional dollar of disposable income, consumers will spend 75 cents and save the remaining 25 cents. To close the recessionary gap and reach full employment, aggregate demand needs to increase. One way to achieve this is by increasing government spending, which directly adds to aggregate demand. The question asks how much government spending should be increased, so we can use the following equation: ΔY = (1 / (1 - MPC)) * ΔG Where: ΔY = change in equilibrium output (in this case, the amount needed to reach full employment) MPC = marginal propensity to consume (0.75) ΔG = change in government spending Plugging in the numbers: ΔY = (1 / (1 - 0.75)) * ΔG ΔY = 4 * ΔG We know that the recessionary gap is $1 trillion (the distance between E₁ and the potential output line), so we need to increase aggregate demand by this amount to reach full employment. Therefore: ΔY = $1 trillion 4 * ΔG = $1 trillion ΔG = $250 billion So we need to increase government spending by $250 billion to close the recessionary gap and reach full employment. This means choice D is the correct answer, as it suggests increasing government spending by $2 trillion, which is equivalent to 8 times the necessary amount.

Exhibit 20A-4 Macro AD/AS Model as Shown in Exhibit 20A-4