Suppose the closed economy is in long-run equilibrium. Advances in technology shift the long-run aggregate-supply curve $80 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 0.75, by how much must the government cut its spending?
A) $4 billion
B) $40 billion
C) $75 billion
D) $150 billion

Question

Quizplus · Accepted Answer

With the shift in AD, the economy will experience an inflationary gap. To stabilize the price level, the government will need to reduce aggregate demand by reducing its own spending.

The initial shift in AD is $150 billion, but to know the amount of government spending cuts required, we need to calculate the new equilibrium output level.

The multiplier effect of the change in AD is:
$150 billion = MPC × ΔY
$150 billion = 0.75 × ΔY
ΔY = $200 billion

So, the new equilibrium output level after the technology shock and the shift in AD is $80 billion + $200 billion = $280 billion.

To stabilize the price level at its original value, we need to bring AD back to its initial level, which means reducing it by $150 billion.

The crowding-out effect is always half of the multiplier effect, so the government will need to reduce its spending by 0.5 × MPC × $150 billion to reduce AD back to its original level.

0.5 × 0.75 × $150 billion = $56.25 billion

Therefore, the government will need to reduce its spending by $56.25 billion to stabilize the price level at its original value. However, since the answer choices do not precisely match this value, the closest answer is B, $40 billion.

Suppose the Closed Economy Is in Long-Run Equilibrium