If no fiscal policy changes are implemented, suppose the future aggregate demand curve will exceed the current aggregate demand curve by \(\$ 500\) billion at any level of prices. Assuming the marginal propensity to consume \((M P C)\) is 0.80 this increase in aggregate demand could be prevented by a. increasing government spending by \(\$ 500\) billion. b. increasing government spending by \(\$ 140\) billion. c. decreasing taxes by \(\$ 40\) billion. d. increasing taxes by \(\$ 125\) billion.

The multiplier effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon the household’s marginal decisions to spend, called the marginal propensity to consume or MPC, or to save, termed as the marginal propensity to save (MPS). Given that the MPC is 0.80, the MPS would be 1 - MPC = 0.20. The multiplier \( k \) can be calculated as: \( k = \frac{1}{MPS} \).

Inserting our given value for MPS into the formula, we get \( k = \frac{1}{0.20} = 5 \).

As per the multiplier effect, a change of \$x in government spending or taxation will result in a \$k*x change in aggregate demand. Option a suggests increasing government spending by \$500 billion. This change would increase aggregate demand by \(5 * \$500\, billion = \$2500 \, billion \), which is too large; we’re aiming to prevent an increase of only \$500 billion. Option b proposes an increase in government spending by \$140 billion. This would increase aggregate demand by \(5 * \$140\, billion = \$700\, billion \), which is still more than our target of \$500 billion. Option c suggests a decrease in taxes by \$40 billion. This would increase disposable income, and thus consumption and aggregate demand, by \(5 * \$40 \, billion = \$200\, billion\), which is less than our target. Option d recommends an increase in taxes by \$125 billion. Interestingly, an increase in taxes reduces the amount of disposable income available for consumers, which decreases aggregate demand. This would result in a decrease of \( 5 * \$125\, billion = \$625\, billion \) in aggregate demand, effectively offsetting the increase.

The best option to prevent a \$500 billion increase in aggregate demand, given an MPC of 0.80, would be to increase taxes by \$125 billion (option d). This would create a decrease of \$625 billion in aggregate demand, effectively offsetting the increase.