Exhibit 15-7 Aggregate demand and supply model

-Suppose the economy in Exhibit 15-7 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.75.Following Keynesian economics,to lower the price level from 170 to 150 the government should raise taxes by:

Question

Exhibit 15-7 Aggregate demand and supply model
 
-Suppose the economy in Exhibit 15-7 is in equilibrium at point E₁ and the marginal propensity to consume (MPC)is 0.75.Following Keynesian economics,to lower the price level from 170 to 150 the government should raise taxes by:

Quizplus · Accepted Answer

According to the Keynesian model, to lower the price level from 170 to 150, we need to decrease aggregate demand. One way to decrease aggregate demand is to decrease government spending or increase taxes. Since we know the MPC is 0.75, we can use the formula MPC/1-MPC to find the government spending multiplier. In this case, the government spending multiplier is 3 (0.75/0.25). To decrease aggregate demand by $40 billion (the difference between the original equilibrium output level and the new equilibrium output level), the government needs to decrease spending or increase taxes by $40 billion/3, which is approximately $13.3 billion. However, the question specifically asks for the increase in taxes needed, so the answer is $133 billion (since a tax increase of $133 billion will decrease disposable income by $100 billion, which is the amount needed to decrease aggregate demand by $40 billion).

Exhibit 15-7 Aggregate Demand and Supply Model