Exhibit 17-2 Aggregate demand and supply model

-Suppose the economy in Exhibit 17-2 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.75.Following Keynesian economics,the federal government can move the economy to point E₂ and reduce inflation by:
A)increasing government spending by $50 billion.
B)decreasing government spending by $6 billion.
C)decreasing government spending by $50 billion.
D)decreasing government spending by $100 billion.

Question

Exhibit 17-2 Aggregate demand and supply model
 
-Suppose the economy in Exhibit 17-2 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.75.Following Keynesian economics,the federal government can move the economy to point E₂ and reduce inflation by:
A)increasing government spending by $50 billion. 
B)decreasing government spending by $6 billion. 
C)decreasing government spending by $50 billion. 
D)decreasing government spending by $100 billion.

Quizplus · Accepted Answer

According to the Keynesian economics model, reducing government spending would shift the aggregate demand curve leftward and move the economy to a new equilibrium point with lower price level and output. The amount of spending cut necessary to move to point E₂ can be calculated as follows:

ΔY = (1/MPS) x ΔG

where MPS is the marginal propensity to save (1 - MPC), and ΔG is the change in government spending.

Using the values in the diagram, we can solve for ΔY = 200 - 100 = 100 and MPS = 0.25. Therefore,

ΔG = (ΔY x MPS) / (1 - MPS) = (100 x 0.25) / 0.75 = 33.33

Rounding up to the nearest billion, the answer is C) decreasing government spending by $50 billion.

Exhibit 17-2 Aggregate Demand and Supply Model