Exhibit 20-4 Macro AD/AS Model

As shown in Exhibit 20A-4, assume the marginal propensity to consume 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 20-4 Macro AD/AS Model

As shown in Exhibit 20A-4, assume the marginal propensity to consume 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

According to the model, the economy is operating at a point that is below full employment (E ₁). This means that there is a recessionary gap (the output gap between potential GDP and actual GDP). To close this gap and restore the economy to full employment, the government should implement expansionary fiscal policy, which means an increase in government spending (as shown by the rightward shift of the AD curve). The size of the spending increase would depend on the size of the output gap and the multiplier effect, which is determined by the marginal propensity to consume. Assuming a marginal propensity to consume of 0.80, the government should increase spending by $1.6 trillion (which is 0.8 times the output gap of $2 trillion). Therefore, the best choice is A.