Question

If no fiscal policy changes are made, suppose the current aggregate demand curve will increase horizontally by \(\$ 1,000\) billion and cause inflation. If the marginal propensity to consume \((M P C)\) is \(0.80,\) federal policymakers could follow Keynesian economics and restrain inflation by decreasing a. government spending by \(\$ 200\) billion. b. taxes by \(\$ 100\) billion. c. taxes by \(\$ 1,000\) billion. d. government spending by \(\$ 1,000\) billion.

Short answer

The correct policy option according to Keynesian economics principles to restrain inflation in this scenario is to decrease government spending by \(\$200\) billion. This option will counterbalance the impact of the increase in the aggregate demand curve by \(\$1,000\) billion, maintaining a stable economic situation and preventing inflation.

Step-by-step solution

Understand the Keynesian Economics Concepts

Keynesian economics is a theory that says the government should increase demand to boost growth. In this exercise, we need to find a fiscal policy to restrain inflation by affecting the aggregate demand curve. The basic concept of Keynesian economics is that when there is a change in fiscal policy, it creates a multiplier effect on the economy: \(Multiplier = \frac{1}{1-MPC}\) The multiplier measures the overall impact of fiscal policy changes on the economy. If the multiplier is high, a small change in fiscal policy will have a large impact on the economy. Now let's use this concept on the given policy options to restrain inflation.

Calculate the multiplier

We are given that the marginal propensity to consume (MPC) is \(0.80\). Using the multiplier formula: \(Multiplier = \frac{1}{1-MPC} = \frac{1}{1-0.80} = \frac{1}{0.20} = 5\) This means that any change in fiscal policy (increase or decrease in taxes or government spending) will have five times the impact on the economy.

Evaluate Policy Options

Given that the aggregate demand curve will increase horizontally by \(\$1,000\) billion and cause inflation, our goal is to restrain this impact through fiscal policies like changing government spending or taxes. a. Government spending decrease by \(\$200\) billion: This will have a total impact of \(\$200\) billion x 5 (multiplier) = \(\$1,000\) billion decrease in aggregate demand curve. b. Taxes decrease by \(\$100\) billion: This will lead to an increase in the aggregate demand, which is not our goal to restrain inflation. So this option isn't suitable. c. Taxes decrease by \(\$1,000\) billion: This will have an even more significant impact on increasing aggregate demand and thus further increase inflation, making it unsuitable. d. Government spending decrease by \(\$1,000\) billion: This will have an enormous impact on decreasing the aggregate demand by \(\$5,000\) billion, which might lead to a severe recession and is not our goal to just restrain inflation.

Choose the Correct Policy Option

By evaluating all policy options in Step 3, we can see that option (a) - decreasing government spending by \(\$200\) billion - is the most suitable choice to restrain inflation according to the Keynesian economics principles. This option will neutralize the impact of the increase in the aggregate demand curve, helping us achieve a balanced scenario and preventing inflation.

Key concepts

Aggregate Demand

In the context of Keynesian economics, understanding aggregate demand is crucial to analyzing how an economy operates. Aggregate demand is the total quantity of goods and services demanded at different price levels in an economy. It can be represented visually by a downward-sloping curve on a graph where the horizontal axis measures the output or the real GDP, and the vertical axis represents the price level.

The aggregate demand curve shifts to the right when there is an increase in consumption, investment, government spending, or net exports, reflecting an escalation in overall economic activity. However, this shift could cause inflation if it is too rapid or sizeable, as it might indicate demand outpacing the economy's capacity to produce goods and services. Therefore, understanding the factors that cause shifts in aggregate demand is vital for policymakers aiming to maintain stable economic growth.

Fiscal Policy

The term fiscal policy refers to the use of government spending and taxation to influence the economy. It is one of the main tools that governmental bodies have at their disposal to manage economic growth, curb inflation, and alleviate recessions. When aggregate demand is below the potential output of the economy, fiscal policy can be expansionary, involving increased government spending or tax cuts to stimulate demand. Conversely, contractionary fiscal policy is enacted to decrease aggregate demand by reducing government spending or increasing taxes.

The effectiveness of fiscal policy is often debated, but according to Keynesian economics, it plays a significant role in managing economic fluctuations. For example, during a period of high inflation, a government might use contractionary fiscal policy to 'cool down' the economy and prevent an overheating that can lead to runaway prices.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) measures the proportion of additional income that a household is likely to spend rather than save. It is a fundamental concept within Keynesian economics, as it influences the size of the multiplier effect that occurs following a change in fiscal policy.

If the MPC is high, it implies that households are more likely to spend their extra income, which can in turn significantly amplify the effects of government spending or tax changes on the overall economy. For instance, with an MPC of 0.80, it indicates that for every extra dollar received, individuals will spend 80 cents and save 20 cents. This level of consumption helps drive the economy, but it can also lead to inflation if the aggregate demand increases too quickly.

Government Spending

Keynesian economics places important emphasis on government spending as a tool for regulating the economy's performance. This spending can include investments in infrastructure, social programs, and other public services, which can directly inject money into the economy and increase aggregate demand. Moreover, government spending can have a multiplier effect, where the initial amount spent by the government leads to a greater increase in income and, consequently, spending by individuals and businesses.

For instance, a decrease in government spending by \(200 billion, considering an MPC of 0.80, would effectively reduce aggregate demand by \)1,000 billion due to the 5-times multiplier effect. This reduction can be a strategic move to counteract inflationary pressures without the risk of causing an excessive economic downturn.