Using fiscal policy to combat a recession The following graph shows aggregate de

Question

Using fiscal policy to combat a recession The following graph shows aggregate demand (AD) and aggregate supply (AS) curves for a hypothetical economy. Suppose the full employment output level in this economy is $300 billion. In order to move the economy to full-employment output at the lowest possible price level, the aggregate demand curve must shift to the right by at each price level. Use the green fine (triangle symbols) ro show the shift in aggregate demand necessary to return the economy to full employment. Then use the purple drop lines (diamond symbol) to show the macroeconomic equilibrium at full-employment output. Be sure the new aggregate demand curve (AD_2) is parallel to AD_1. You can click on AD_1 to see its slope. Suppose the government in this economy wants to enact fiscal policies that will shift the aggregate demand curve in the direction and magnitude you indicated. The marginal propensity to consume (MPC) in this economy is 0.80. This implies a spending multiplier of and a tax multiplier of.

Explanation / Answer

The first answer is $40 billions (= 300-260) i.e Present real gdp minus full employment level of real gdp. Remember, full employment level of gdp means all the resouces in the economy is fully and efficiently utilised. The AS curve cannot be moved to higher real gdp with given resources. The economy has to increase its resources in order to move to higher real gdp level. That's why we have subtracted $260 billion from $300 billion.

Spending multiplier= 1/1-MPC = 1/1-0.8 = 1/0.2= 5

The formula for tax multiplier = -MPC/1-MPC = -MPC/MPS = -0.8/0.2 = -4.

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