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 (MPC) 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

A

Explanation:

Going by the above scenario, federal policymakers could follow Keynesian economics and restrain inflation by reducing government spending by $200 billion.

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A) government spending by $200 billion

Explanation:

The government spending multiplier is calculated by dividing 1 by marginal propensity to save.

marginal propensity to save (MPS) = 1 - MPC = 1 - 0.8 = 0.2

government multiplier = 1 / 0.2 = 5

since we need to reduce aggregate demand by $1,000 billion, then we need to decrease spending by:

spending decrease x multiplier = $1,000 billion

spending decrease = $1,000 billion / 5 = $200 billion