Suppose the economy is in long-run equilibrium. Parliament passes regulations that make it more costly to conduct business, so the long-run aggregate-supply curve shifts $80 billion to the left. At the same time, government purchases increase by $60 billion. If the MPC equals 0.8 and the crowding-out effect is $70 billion, what would we expect to happen in the long run to real GDP and the price level?
A) Both real GDP and the price level would be higher.
B) Both real GDP and the price level would be lower.
C) Real GDP would be lower, but the price level would be higher.
D) Real GDP would be lower, but the price level would be the same.

Question

Quizplus · Accepted Answer

The shift of the long-run aggregate-supply curve to the left indicates that the cost of doing business has increased, which means that firms will produce less output to maintain their profits at the same price level. This leads to a decrease in real GDP in the long run. However, government purchases increased by $60 billion, which will increase aggregate demand. The MPC of 0.8 means that the increase in government purchases will lead to a $48 billion increase in consumption, which will further increase aggregate demand. The crowding-out effect of $70 billion, which occurs when government purchases increase and interest rates rise, will reduce private investment and partially offset the increase in aggregate demand. Therefore, the increase in government purchases will not fully compensate for the decrease in output caused by the increase in the cost of doing business. As a result, in the long run, real GDP will be lower, but the increase in aggregate demand will lead to a higher price level.

Suppose the Economy Is in Long-Run Equilibrium