Question

Suppose that the economy is in a long-run equilibrium at a price level of 100 and full-employment real GDP of $500 billion. An expansion occurs resulting from a $100 billion increase in aggregate demand. In order to restore the economy to full employment, given a MPC of 0.80, government purchases would need to:

Answer 1

In order to restore the economy to full employment, there is a need to decrease the actual output (AD) by $100 billion.

=> ΔY = -$100 billion.

MPC = 0.80

Government spending multiplier = 1 / (1-MPC)

=> Government spending multiplier = 1 / (1 - 0.8)

=> Government spending multiplier = 1/ 0.2

=> Government spending multiplier = 5

Government spending multiplier = ΔY /ΔG

=> 5 = (-$100 billion / ΔG)

=> ΔG = (-$100 billion / 5)

=> ΔG = -$20 billion

Hence, government purchases would need to decrease by $20 billion.