Suppose the closed economy is in long-run equilibrium. Pessimism on the part of investors then shifts the aggregate demand curve $50 billion to the left. The government wants to increase 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, by how much do government purchases have to rise?
A)$10 billion
B)$20 billion
C)$50 billion
D)$100 billion

Question

Quizplus · Accepted Answer

The multiplier effect is calculated as 1/(1-MPC) = 1/(1-0.8) = 5. The crowding-out effect is half as strong, so the net multiplier is 5 - 0.5*5 = 2.5. To offset a $50 billion decrease in aggregate demand, government purchases must rise by $50 billion / 2.5 = $20 billion.

Suppose the Closed Economy Is in Long-Run Equilibrium