Question

Suppose the economy is experiencing a recessionary gap of $0.5 trillion. The marginal propensity to consumer is MPC = 0.2. To mitigate or close the gap, the fiscal government need to choose between two options: increase government spending G or decrease taxes. Fill in the gaps with numerical answers unless otherwise instructed. Round your answers to one decimal place (for example, 1.25 ~ 1.3).

1. The value of the spending multiplier is at most equal to .
2. The value of the tax multiplier is at most equal to .
3. Suppose the government chooses to not change the taxes. Then, it should increase spending by at least $ trillion in order to close the gap.
4. Suppose the government chooses to not change government spending. Then, it should decrease taxes by at least $ trillion in order to close the gap.

Answer 1

MPC = 0.2

Government Spending Multiplier = 1 / (1-MPC)

Government spending multiplier = 1 / (1-0.2)

Government spending multiplier = 1 / 0.8

Government spending multiplier = 1.25

Government spending multiplier = 1.3 (After round off)

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Tax multiplier = -MPC / (1-MPC)

Tax multiplier = -0.2 / (1-0.2)

Tax multiplier = -0.25

Tax multiplier = -0.3 (After round off)

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economy is experiencing a recessionary gap of $0.5 trillion. In order to close the recessionary gap, there is need to increase in output (Y) by $0.5 trillion

=> ΔY = $0.5 trillion

Government spending multiplier = ΔY /ΔG

=> 1.25 = $0.5 trillion/ ΔG

=> ΔG = $0.5 trillion/ 1.25

=> ΔG = $0.4 trillion.

Suppose the government chooses to not change the taxes. Then, it should increase spending by at least $0.4 trillion in order to close the gap.

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Tax multiplier = ΔY / ΔT

=> -0.25 = $0.5 trillion / ΔT

=> ΔT = $0.5 trillion / (-0.25)

=> ΔT = -$2 trillion

Suppose the government chooses to not change government spending. Then, it should decrease taxes by at least $ 2 trillion in order to close the gap