Question

If the MPC in an economy is .8, government could shift the aggregate demand curve rightward by $100 billion by: decreasing taxes by $25 billion. increasing government spending by $25 billion. increasing government spending by $80 billion. decreasing taxes by $100 billion.

Answer 1

Option 1

decreasing taxes by $25 billion

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tax multiplier =-MPC/(1-MPC)

=-0.8/(1-0.8)

=-4

the required change in taxes =required change in aggregate demand /tax multiplier

=100/(-4)

=-25 billion

the minus sign denotes decrease

required to decrease taxes by $25 billion

or

Spending multiplier =1/(1-MPC)

=1/(1-0.8)

=5

change in spending =required change in aggregate demand /spending multiplier

=100/5

=20 billion

the government should increase government spending by $20 billion to increase AD by $100 billion