Suppose that the federal government has identified a recessionary gap of $250 billion. If they decide...

Suppose that the federal government has identified a recessionary gap of $250 billion. If they decide to use fiscal policy, what type of fiscal policy should they adopt? Calculate both of their options (and be specific about direction) considering that the MPC = 0.75.

Expert Solution

In case of recessionary gap the Federal government uses the expansionary fiscal policy. It means that it will either increase government spending or decrease taxes in order to increase aggregate demand and output such that the recessionary gap is eliminated.

Government spending multiplier= 1/(1–MPC)= 1/(1–0.75)= 4

Tax Multiplier= –MPC/(1–MPC)= –3.

Required Increase in Output= Recessionary Gap= $250 billion

Change in Governnment spending Required to eliminate Recessionary Gap= required increase in output /government spending multiplier

Change in government spending required to eliminate recessionary gap= $250/4= $62.5 billion

So in order to eliminate the recessionary gap the government spending must be increased by $62.5 billion

Change in taxes required to eliminate recessionary gap= required increase in output/tax multiplier

Change in taxes required to eliminate recessionary gap= 250/–3= –$83.33 billion

So in order to eliminate the recessionary gap the taxes should be Decreased by $83.33 billion.

Rahul Sunny answered 9 months ago

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