Exhibit 17-1 Aggregate demand and supply model

-Suppose the economy in Exhibit 17-1 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.8.Following Keynesian economics,to restore full employment,the government should increase its spending by:
A)$200 billion.
B)$250 billion.
C)$500 billion.
D)$1 trillion.

Question

Exhibit 17-1 Aggregate demand and supply model
 
-Suppose the economy in Exhibit 17-1 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.8.Following Keynesian economics,to restore full employment,the government should increase its spending by:
A)$200 billion. 
B)$250 billion. 
C)$500 billion. 
D)$1 trillion.

Quizplus · Accepted Answer

To restore full employment, the government should increase its spending by an amount that, when multiplied by the spending multiplier, equals the gap in GDP. The spending multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. If the gap is $1 trillion, the government should increase spending by $1 trillion / 5 = $200 billion.

Exhibit 17-1 Aggregate Demand and Supply Model