Attempts: 2 Do No Harm: 2/11 Aa Aa 2. Contractionary fiscal policy in the AD-AS
ID: 1103773 • Letter: A
Question
Attempts: 2 Do No Harm: 2/11 Aa Aa 2. Contractionary fiscal policy in the AD-AS model Suppose an economy is initially at point F in the graph below. At point F, the economy is at its potential output level of $73 billion and a price level of 98. Assume that a sudden increase in investment spending causes aggregate demand to shift to the right, from AD1 to AD2 PRICE LEVEL 105 AD3 103 New Equilibrium 101 AD2 97 AD1 95 70 72 74 76 78 80 REAL DOM, OUTPUT, GDO!Billions of dollar%) oman According to the ratchet effect, an increase in aggregate demand that pushes output above potential output tends to the price level, and a decrease in aggregate demand (regardless of the output level) tends to the price level.Explanation / Answer
Increase price level
decrease price level
from point F to point R
By comparing new and old equilibrium, we get GDP gap as 4 units ( 77-73 units (billions of dollars))
since MPC=0.6, the value of the multiplier is 2.5. This means, that an increase in taxes by 1.6 billion will result in a decrease in aggregate demand by 4 billion (2.5 X 1.6) Thus option 5 is correct. using the same logic, option 4 is also correct.
if govt purchases were to decrease by 2 billion and taxes were to increase by 2 billion, then aggregate demand would decrease by 10 billion = (2x 2.5) +(2 x 2.5 ). This will more than account for the GDP gap therefore not correct. using the same logic we can conclude that both option 1 and 2 are incorrect. Option 1 would result in a decrease in aggregate demand by 6.675 billion whereas option 2 will result in a decrease in aggregate demand by 6 billion.
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