PLEASE ANSWER THIS QUESTION CORRECTLY Aa Aa 2. Expansionary fiscal policy in the

Question

PLEASE ANSWER THIS QUESTION CORRECTLY

Aa Aa 2. Expansionary fiscal policy in the AD-AS model A hypothetical economy was originally operating at its potential output level of $132 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 D1 AD2 110 100 120 124 128 132 136 140 REAL DOM. OUTPUT, GDP (Billions of dollars)

Explanation / Answer

The decrease in aggregate demand opens up a GDP gap of $8bn ( = 132 - 124)

The multiplier for this economy = Final shift/Initial shift = (132 -124)/(126 - 124) = 4 (=1/(1- MPC))

Tax multiplier = -MPC/(1 - MPC) = - 3

Correct options:

(In order to shift the AD curve by $8 bn)

- Decrease taxes by $2.67 bn (2.67 x 3 = 8)

- Increase government expenditures by $2 bn ( 2 x 4 = $8 bn)

- Increase government expenditures by $1.25 bn and decrease taxes by $1 bn ( 1.25 x 4 + 3 x 1 = $8 bn)

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