Suppose the closed economy is in long-run equilibrium. Advances in technology shift the long-run aggregate supply curve $75 billion to the right. Optimistic investors have shifted the aggregate demand curve $150 billion to the right. In order to stabilize the price level at its original value, the government wants to reduce its spending. If the crowding-out effect is always half of the multiplier effect, and if the MPC equals 0.8, by how much must the government cut its spending?
A)$4 billion
B)$30 billion
C)$75 billion
D)$150 billion

Question

Quizplus · Accepted Answer

Since AD has shifted $150 billion to the right and the vertical shift of the AS curve caused by the technological advances has shifted it $75 billion to the right, there is an excess demand of $75 billion at the original price level. In order to stabilize the price level, the AD curve must shift left by the $75 billion that represents the excess demand.

Using the formula for the multiplier effect:

$75 billion excess demand / (1 - MPC) = $375 billion shift in AD

The government needs to cut its spending by half of the $375 billion shift in AD, or $187.5 billion.

Therefore, the answer is not listed, but by dividing $187.5 billion by the MPC of 0.8, we get a reduction in government spending of $234.375 billion. However, the question is asking for the approximate figure. The closest answer is B, $30 billion.

Suppose the Closed Economy Is in Long-Run Equilibrium