1. Expansionary fiscal policy in the AD-AS model A hypothetical economy was orig
ID: 1103748 • Letter: 1
Question
1. Expansionary fiscal policy in the AD-AS model A hypothetical economy was originally operating at its potential output level of s132 billion and a price level of 130. This is illustrated by point A in the graph below. A sudden reduction in investment shifts the aggregate demand curve to the left, from AD1 to AD2. Assume that prices are inflexible downward at a price level of 130. This means that the decrease in aggregate demand will not put downward pressure on prices. Since the price level remains at 130, the decrease in aggregate demand causes economic output to decline from $132 billion (point A) to $124 billion (point B). PRICE LEVEL 150 140 AS 130 120 AD3 AD1 110 AD2 100 120 124 128 132 136 140 REAL DOM. OUTPUT, GDP (Billions of dollars)Explanation / Answer
1. GDP gap = 132 - 124 = $8 billion
2. Multiplier = 1/(1-MPC) = 1/(1-0.75) = 1/0.25 = 4
3. Correct options: (a) decrease tax by 2.67 ; (e) increase government purchases by 2 ; (c) increase government purchases by 1.25 and decrease taxes by 1
Reason: Tax multiplier = MPC/(1-MPC) = 0.75/025 = 3
Government purchase multiplier = 1/(1-MPC) = 1/(1-0.75) = 4
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