# Macroeconomics: Aggregate Demand, Equilibrium Dynamics and Expenditure Multipliers

I am having a hard time with the following economic questions (See attached). Here is my approach:

Note about the curves: The graph below depicts an economy where a decline in aggregate demand has caused a recession. Assume the government decides to increase government purchases as fiscal policy to reduce the burden of this recession.

1. How much does aggregate demand need to increase to reach long-run equilibrium?

A: 100 billion Because that's the AD1-AS equilibrium to AD1-LRAS line

2. MPC =.75 (and thus MPS = .25)

How much do government purchases need to increase to shift aggregate demand by the amount you found in part 1)?

My logic: The expenditure multiplier = 1/MPS = 1/(.25) =4

Delta Y from 1) is 100 billion

Therefore, 4X= 100 (x = government purchases) leading to x = 25

3. Suppose the MPC is 0.6. To restore the economy to its long-run equilibrium, aggregate demand must be increased by i) ___________ and government purchases must be increased by ii) ________________

Delta Y is the same as 1), so it's 100 billion for i)

MPS changes to .6, so the multiplier is 1/.4 = 2.5, 100/2.5 = 40 billion in government purchases to restore long-run equilibrium.

### So then, how are my answers wrong according to the program?

• Can you share the link to this program. I think your answers are correct. There may be some technical problem with the website. – Sub-Optimal Jul 12 '16 at 6:17
• @AbhinavArya From the image, I get ezto.mheducation.com/hm.tpx?_=0.8615001729195662_1468297017185 but that leads nowhere. mheducation.com does however. I'm not sure external have access to it though. – clem steredenn Jul 12 '16 at 19:20
• The URL did not lead me where I wanted to. Anyways, your answer is correct. It must be some technical problem. I failed to find anything wrong in your solution. – Sub-Optimal Jul 12 '16 at 22:39

## 2 Answers

1. In shifting the$\ AD_1 \rightarrow AD$ curves to achieve long run equilibrium, Real GDP will have to increase by 200 billion. Refer to the diagram below, (in purple).

1. $\ MPC = 0.75 \rightarrow MPS = 0.25$

In this 3 sector closed-economy model, the multiplier can be calculated using :

$$\ K = \frac{1}{MPS+MPT}$$

Assuming MPT (Marginal Propensity to Tax) = 0, then $\ K = \frac{1}{MPS} = \frac{1}{0.25} = 4$

$\ \Delta Y=K\Delta (AE)$, considering only government expenditure, then $\ \Delta Y=K\Delta G$

Substituting the values, $\ 200B = 4G \rightarrow G = 50$

1. If currently, the $\ AD$ component is $\ AD = 400B$ at $\ MPC = 0.75$, then we can calculate the original income, $\ Y = (0.75)^{-1} \times AD = (0.75)^{-1} \times 400Bil = 533.33Bil$

Now using this value of $\ Y$, we can calculate the new $\ AD$ component at $\ MPC = 0.6$, which is $\ AD_{new} = 0.6 \times 533.33Bil = 320Bil$

Hence, using the same approach as in Part 1, the lime-green line is $\ AD_{new}$, the purple section represents $\Delta AD,$ which, as in Part 2, with a new multiplier of $\ K$ calculated using the new $\ MPS = 0.4$, and substituting those values into $\ \Delta Y=K\Delta G$ will result in your new government expenditure.

1. 200 billion

Look at P = 80. If you shift the aggregate demand curve over by 100, the AD curve will intersect the LRAS at P = 80 instead of P = 100. You need to shift it by 200.

1. 50

Since the answer to 1 has changed so has 2.

1. 80 billion

Same as 2.