Exhibit 15-5 Aggregate demand and supply model

-Suppose the economy in Exhibit 15-5 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:

Question

Exhibit 15-5 Aggregate demand and supply model
 
-Suppose the economy in Exhibit 15-5 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:

Quizplus · Accepted Answer

According to the Keynesian economics, to reduce inflation, the government should decrease government spending. To calculate the amount of the decrease, we need to use the multiplier effect. The multiplier effect shows the impact of changes in spending on GDP. The formula for the multiplier effect is 1/(1-MPC).

In this case, the MPC is 0.75, therefore the multiplier effect is 1/(1-0.75)=4.

To move the economy from point E₁ to point E₂, we need to decrease the aggregate demand by $200 billion (the distance between the two points). To calculate the amount of the decrease in government spending needed, we divide the desired decrease in aggregate demand by the multiplier effect:

$200 billion / 4 = $50 billion

Therefore, the government should decrease government spending by $50 billion to reduce inflation and move the economy from point E₁ to point E₂.

Choice D is the correct answer.

Exhibit 15-5 Aggregate Demand and Supply Model