Aggregate Demand / Aggregate Supply Model The above shows an economy in recessio
ID: 1159574 • Letter: A
Question
Aggregate Demand / Aggregate Supply Model
The above shows an economy in recession. Equilibrium GDP was $15 trillion. As a result of decreased consumer spending, AD has fallen (from AD to AD’) causing a decrease in GDP down to $12 trillion. Fiscal policy can be used to return the economy back to a state of equilibrium.
A. If the MPC = 0.85 and the government chooses to increase government expenditures, how much should this initial increase in spending be? How big will the multiplier effect be?
B. Discuss how the AD curve will shift as a result of the policy you described in part a.
C. If it is decided that a tax decrease is better than a spending increase, how much should taxes be decreased? (3pts)
D. Suppose, now the MPC = 0.99, what would be the new initial change in spending? Has it increased or decreased as compared to part a? Explain the economic reasons for this increase or decrease.
E. If the MPS increases from what it was in part a, how will your answer from part c, change? Explain why this change occurs.
F. Could “crowding-out” happen as the result of the policy discussed in part a? Why?
G. In the AD/AS graph above, the Price Level stays constant when AD falls. What is this situation called? Explain two reasons why it occurs. (6pts)
Level Price AS AD AD Strillion RGDP $12 $15Explanation / Answer
Ans
A multiplier=1/1-0.85=1/0.15=6.67
Required increase=15-12/6.67 trillion=0.45 trillion
B AD will shift rightwards back to AD
C tax multiplier=-mpc/1-mpc=5.67.so required increase in taxes=3/5.67=0.53
D multiplier=1/1-mpc= 1/0.01=100
So increase=3/100=0.03 trillion
Thus less change is required because people consume more and spend less leading to higher multiplier
E taxes should be decreased by more since mps is denominator of tax multipluer
F yes because resources are diverted from private sector
G stagflation. The reason are cost increase, price rise and lower purchasing power