Assume that the full-employment level of output is $500, and the price level associated with full-employment output is 100. Also assume that the economy's current level of output is $450 and, at the price level of 100, current aggregate demand is $400. If the government wants to move the economy back to the full-employment level of output and the MPC is 0.75, then it should .a. reduce government purchases by $100.
b. increase government purchases by $100.
c. reduce government purchases by $25.
d. increase government purchases by $25.

d. increase government purchases by $25.

Explanation:

Assume that the full-employment level of output is $500, and the price level associated with full-employment output is 100. Also assume that the economy's current level of output is $450 and, at the price level of 100, current aggregate demand is $400. If the government wants to move the economy back to the full-employment level of output and the MPC is 0.75, then it should increase government purchases by $25.

D) increase government purchases by $25.

Explanation:

To determine the total impact of an increase in government spending, we need to calculate the government spending multiplier (Gm).

Gm = 1 / MPS

MPS = 1 - MPC = 1 - 0.75 = 0.25

Gm = 1 / 0.25 = 4

Since the government increases spending by $25 billion, the total impact on aggregate demand = $25 billion x 4 (Gm) = $100 billion

Now aggregate demand will be $500 billion.

Total output should increase by a little less = $100 billion x MPC = $100 billion x 0.75 = $75 billion

In this case total output will increase to $525 billion, which is a little higher than intended, but all the other options were much farther away. Once we include the effects of taxes and crowding out effect on the equation, both aggregate demand and total output should decrease a little but we do not have any other information. So the net increase should be closer to $500 billion.

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