The graph below depicts an economy where an increasenggregete demand has caused

Question

The graph below depicts an economy where an increasenggregete demand has caused inflation. Assume the government decides to change taxes as fiscal policy to bring inflation under control Fiscal Policy 200 180 160 140 120 LRAS AS AD 80 60 40 20 AD 480 Real GDP (billions of dollars) a. How much does aggregate demand need to change to restore the economy to its long-run equillbrium? b. Assuming the MPC In this nation is 075, how much do taxes need to change to shift aggregate demand by the amount you found i . Now suppose the MPC Is 06. To restore the economy to ts long-run qullbrfium, aggregate demand must billion part a? billion billion and taxes must be changed by sbillion.

Explanation / Answer

1) Aggregate demand needs to be decreased by $520-400=$120billion because of inflationary gap of $120.

2)MPC=0.75 we know tax multiplier=-c/1-c=-0.75/1-0.75=-3

Thus tax multiplier=-3 and change in AD required=-120

Thus tax multiplier=Change in AD/Change in tax

Change in tax=-120/-3=40

Thus tax should be increased by 40billion.

3)MPC=0.6 then tax multiplier=-0.60/40=-1.5

Aggregate demand need to be decrease by $120billion only

Thus increase im tax required=120/1.5=$80billion

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