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Initially, the economy is in long-run equilibrium. The aggregate demand curve then shifts $80 billion to...

Initially, the economy is in long-run equilibrium. The aggregate demand curve then shifts $80 billion to the left. The government wants to change spending to offset this decrease in demand. The MPC is 0.75. Suppose the effect on aggregate demand of a tax change is 3/4 as strong as the effect of a change in government expenditure. There is no crowding out and no accelerator effect. What should the government do if it wants to offset the decrease in real GDP?

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Answer: The government should raise both taxes and expenditures by $80 billion dollars. The combination of both policies( increasing taxes and increasing government spending) because income is the main factor driving consumer demand. An increase in tax will reduce disposable income, because it takes money out of households. Similarly increasing government expenditure will offset the decrease in real GDP

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