Suppose the closed economy is in long-run equilibrium. Technological change shifts the long-run aggregate-supply curve $80 billion to the right. At the same time, government purchases increase by $40 billion. If the MPC equals 0.75 and the crowding-out effect is $70 billion, what would we expect to happen in the long-run to real GDP and the price level?
A) Both real GDP and the price level would be higher.
B) Both real GDP and the price level would be lower.
C) Real GDP would be higher but the price level would be lower.
D) Real GDP would be higher but the price level would be the same.

Question

Quizplus · Accepted Answer

The shift in the long-run aggregate supply will increase potential output, shifting the short-run aggregate supply curve to the right. With an increase in government purchases, aggregate demand will also shift to the right. The crowding-out effect reduces the net increase in aggregate demand by $70 billion. However, with an MPC of 0.75, the multiplier effect will still increase aggregate demand and real GDP. The increase in potential output combined with the increase in aggregate demand will lead to an increase in both real GDP and the price level.

Suppose the Closed Economy Is in Long-Run Equilibrium