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Consider a hypothetical economy in which households spend $ 0 . 8 0 of each additional dollar of their after - tax income. Suppose that

Consider a hypothetical economy in which households spend $0.80 of each additional dollar of their after-tax income. Suppose that this economy is experiencing a recession. The government would like to stimulate aggregate demand and is deciding whether it should increase its spending by $1 billion or reduce income tax by $1 billion. Assume other things remain constant, and the marginal propensity to consume remains at 0.8.
a) How much would a $1 billion increase in government spending increase aggregate demand?
b) How much would a $1 billion reduction in income tax increase aggregate demand?
c) Alternatively, suppose the hypothetical economy is $7.5 billion below its long-run equilibrium. All else equal, how much should government spending increase to close this gap?

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