Initially, the economy is in long-run equilibrium. The aggregate demand curve then shifts $40 billion to the left. The government wants to change its spending to offset this decrease in demand. The MPC is 0.60. Suppose the effect on aggregate demand from a change in taxes is 3/5 the size of the change from government expenditures. There is no crowding out and no accelerator effect. 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 0.60, so a $40 billion decrease in aggregate demand will lead to a $66.67 billion decrease in real GDP. To offset this, the government needs to increase aggregate demand by $66.67 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 decrease in taxes will increase aggregate demand by $26.67 billion (since the effect on aggregate demand from a change in taxes is 3/5 the size of the change from government expenditures).

Initially, the Economy Is in Long-Run Equilibrium