Question

The graph below depicts an economy where an increase in aggregate demand has caused inflation. Assume the government decides to conduct fiscal policy by decreasing government purchases to restore full-employment GDP Fiscal Policy 180 г 160 140 AS る 100 80 60 40 20 0) AD AD 100 200 300 400 500 600 700 800 900 1000 Real GDP (billions of dollars) Instructions: Enter your answers as a whole number. If you are entering any negative numbers be sure to include a negative sign () in front of those numbers a. How much does aggregate demand need to change to restore the economy to its long-run equilibrium? billion b. If the MPC is 0.75, how much does government purchases need to change to shift aggregate demand by the amount you found in part a? sbillion Suppose instead that the MPC is 0.6 c. How much does aggregate demand and government purchases need to change to restore the economy to its long-run equilibrium? Aggregate demand needs to change by S billion and government purchases need to change by sbillion KPre 4 of 10li Next > DON'T FORGET USB DRIVE

Answer 1

In an effort to address an inflationary gap caused by increased aggregate demand, fiscal policy involving a decrease in government purchases is used to shift the AD curve back towards long-run equilibrium. The precise decrease in spending required depends on the marginal propensity to consume, as it influences the multiplier effect. Real-world implementation of fiscal policy change faces uncertainties due to imprecise potential GDP knowledge and unpredictable economic conditions.

Step-by-step explanation:

When the government decides to conduct fiscal policy by decreasing government purchases, the goal is to shift the aggregate demand (AD) curve back to the left to restore the economy to its long-run equilibrium. Based on Keynesian economics, if the current level of GDP is above potential GDP, creating an inflationary gap, reducing aggregate expenditures either through lower government spending or increased taxes can help realign the AD with potential GDP without inflationary pressures.

However, determining the precise level of decrease in government spending required to shift AD back involves relying on the multiplier effect. For example, with a marginal propensity to consume (MPC) of 0.75, a change in government purchases will have a larger impact than if the MPC was 0.6, due to the fact that consumers are more likely to spend additional income leading to an increased cumulative effect on GDP.

In real-world scenarios, there are uncertainties and complexities, such as not knowing the accurate level of potential GDP and the precise impact fiscal policy changes will have on aggregate demand. Historical instances, like the financial crisis of 2008-2009, highlight these challenges as swift economic changes can make it difficult to ascertain the state of the economy and thus, to implement the right level of fiscal policy adjustments.