The graph below depicts an economy where a decline in aggregate demand has cause

Question

The graph below depicts an economy where a decline in aggregate demand has caused a recession. Assume the government decides to conduct fiscal policy by changing taxes to reduce the burden of this recession. Instructions: Include a negative sign (-) if necessary. How much does aggregate demand need to change to restore the economy to its long-run equilibrium? $_______billion Assuming the MPC in this nation is 0.5, how much do taxes need to change to shift aggregate demand by the amount you found in ? $_____billion Now suppose the MPC is 0.8. To restore the economy to its long-run equilibrium, aggregate demand must be changed by $_______billion and taxes must be changed by $______billion.

Explanation / Answer

(a) $80 billion

Since real GDP = $400 billion (for AD1) and potential GDP = $480 billion (for AD), there is a recessionary gap equal to $(480 - 400) billion = $80 billion.

(b) -$80 billion

Tax multiplier = - MPC / (1 - MPC) = - 0.5 / (1 - 0.5) = - 0.5 / 0.5 = - 1

Required change in tax = $80 billion / (-1) = - $80 billion (decrease in tax)

(c) Aggregate demand must be changed by $80 billion and taxes must be changed by -$20 billion.

Tax multiplier = - MPC / (1 - MPC) = - 0.8 / (1 - 0.8) = - 0.8 / 0.2 = - 4

Required change in tax = $80 billion / (-4) = - $20 billion (decrease in tax)

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