The economy is in long-run equilibrium.The aggregate demand curve shifts $40 billion to the left.The government wants to change its spending to offset this decrease in demand.The MPC is .60.Suppose the effect on aggregate demand from a change in taxes is 3/5 the size of the change from government expenditures.What should the government do if it wants to offset the decrease in real GDP?
A)raise both taxes and expenditures by $40 billion dollars.
B)raise both taxes and expenditures by $40 billion dollars
C)reduce both taxes and expenditures by $10 billion dollars
D)reduce both taxes and expenditures by $10 billion dollars.

Question

Quizplus · Accepted Answer

The government should raise both taxes and expenditures by $40 billion to offset the decrease in real GDP. This is because the MPC is .60, so a $40 billion decrease in aggregate demand will lead to a $24 billion decrease in real GDP. To offset this, the government needs to increase aggregate demand by $24 billion. Raising both taxes and expenditures by $40 billion will do this, as the increase in government spending will increase aggregate demand by $40 billion, and the increase in taxes will decrease aggregate demand by $16 billion (3/5 of $40 billion), for a net increase in aggregate demand of $24 billion.

The Economy Is in Long-Run Equilibrium