Initially, the economy is in long-run equilibrium. Aggregate demand then shifts leftward by $50 billion. The government wants to increase its spending in order to avoid a recession. If the crowding-out effect is always half as strong as the multiplier effect, and if the MPC equals 0.8, then by how much do government purchases have to increase in order to offset the $50 billion leftward shift?
A)by $5 billion
B)by $10 billion
C)by $20 billion
D)by $50 billion

Question

Quizplus · Accepted Answer

The multiplier effect is given by:

1/(1-MPC) = 1/(1-0.8) = 5

Therefore, to offset the leftward shift of $50 billion, government purchases must increase by:

50/5 = 10

However, due to the crowding-out effect, the actual increase in real GDP will be smaller than $10 billion, as some of the increase in government spending will be offset by a decrease in private investment. If the crowding-out effect is always half as strong as the multiplier effect, then the actual increase in real GDP will be:

10 - 0.5(10) = 10 - 5 = $5 billion

Therefore, the government must increase its purchases by $20 billion to offset the leftward shift, but only $5 billion of that increase will be realized in terms of actual GDP growth.

Initially, the Economy Is in Long-Run Equilibrium