Question

Suppose an economy is initially at long run equilibrium. Using LRAS, SRAS and AD graphs, show this initial point and label it as A.

(a)  Due to terrorist attacks, the consumption expenditure decreased by $150 billion. With an MPC of 0.5, illustrate this decline in consumption on the graph in (a) and also compute the impact of the decline in consumption on output level (Y).

(b) If the government wants to use taxes to restore long run equilibrium, should the government increase or decrease taxes, and by how much? Please show all computations

Answer 1

a) The reduction of consumption spending by $150 billion will decrease the aggregate demand by,

Decrease in aggregate demand = multiplier * change in consumption

=> Multiplier = 1/(1-MPC) = 2

Decrease in aggregate demand = 2 * 150 billion = $300 billion

This will shift the aggregate demand to the left from AD to AD’ which will create a condition of excess supply in the market causing price level to fall to P’ from P and output to fall from Y to Y’

b) To restore the equilibrium government needs to increase the aggregate demand by $ 300 billion. The decrease in tax required = $300 billion / tax multiplier

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

So, required decrease in taxes = $300 billion

The decrease in taxes will increase the aggregate demand shifting the curve to the right from AD’ to AD increasing the price level to P and output to Y.

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