2. Fiscal Policy options to address a recessionary gap: Suppose the economy’s MPC is .75 or...

2. Fiscal Policy options to address a recessionary gap: Suppose the economy’s MPC is .75 or 3/4.

A. If the government increases spending by $60 billion, what will the cumulative increase in AD be equal to?

B. If the government decreases taxes by $60 billion, what will the cumulative increase in AD be equal to?

Solutions

Expert Solution

MPC = 0.75

(A) Government spending multiplier = 1 / (1-MPC) = 1 / (1 - 0.75) = 1/ 0.25 = 4

Government increases the spending by $60 billion

Government spending multiplier = (Change in Output / Change in Government spending)

=> 4 = (Change in output / $60 billion)

=> Change in output = 4 * $60 billion

=> Change in output = $240 billion

Thus, the cumulative increase in AD will be $240 billion.

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(B)

Tax multiplier = -MPC / (1 -MPC) = -0.75 / (1 - 0.75) = -0.75 / 0.25 = -3

Taxes decreases by $60 billion.

Tax multiplier = (change in output / change in taxes)

=> -3 = (change in output / (-$60 billion))

=> change in output = -3 * (-$60 billion)

=> change in output = $180 billion

Thus, the cumulative increase in AD will be equal to $180 billion.

Rahul Sunny answered 1 year ago

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