Suppose the economy is operating at an output level of $5,400 billion. Assume furthermore that potential output is $5,000 billion and the marginal propensity to consume is 0.75. _____ would close this inflationary gap.
A)A $400 billion tax hike
B)Raising government purchases of goods and services by $400 billion
C)Decreasing government purchases of goods and services by $100 billion
D)Increasing government purchases of goods and services by $100 billion

Question

Quizplus · Accepted Answer

To close the inflationary gap, the government should decrease spending. With a marginal propensity to consume of 0.75, a $100 billion decrease in government spending will reduce aggregate demand by $400 billion (multiplier effect: 1/(1-0.75) = 4).

Suppose the Economy Is Operating at an Output Level of $5,400