The graph below depicts an economy where an increase in aggregate demand has cau

Question

The graph below depicts an economy where an increase in aggregate demand has caused inflation. Assume the government decides to decrease government purchases as fiscal policy to restore full-employment GDP. Instructions: Include a negative sign (-) if necessary. How much does aggregate demand need to change to restore the economy to its long-run equilibrium? $_______billion Assuming the MPC in this nation is 0.75, how much do government purchases need to change to shift aggregate demand by the amount you found in ? $____billion Now suppose the MPC is 0.6. To restore the economy to its long-run equilibrium, aggregate demand must be changed by $______billion and government purchases must be changed by $_______billion.

Explanation / Answer

(a) -$120 billion

Since real GDP = $520 billion (for AD1) and potential GDP = $400 billion (for AD), there is an inflationary gap equal to $(520 - 400) billion = $120 billion.

(b) -$30 billion

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4

Required change in government spending = - $120 billion / 4 = - $30 billion (decrease)

(c) Aggregate demand must be changed by -$120 billion and government purchase must be changed by -$48 billion.

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.6) = 1 / 0.4 = 2.5

Required change in government spending = - $120 billion / 2.5 = - $48 billion (decrease)

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