Question

Answer two (2) of the following essay questions.

1) How do automatic stabilizers, on both the expenditure and revenue sides of the budget, respond when the economy is in 1) a contractionary 2) an expansionary gap?

2) How much should the government 1) increase spending or 2) cut taxes when the economy is in a contractionary gap equal to 500 billion and the MPC equals 0.8.

3) According to the classical school of economists, the economy is self-correcting. Explain why the economy will automatically move to long run equilibrium (potential output) when it is in an expansionary and in a contractionary gap.

4) Give an account of how an increase in government spending can lead to an increase in the trade deficit.

Answer 1

1) When there is a contractionary gap, government spending automatically increases because of increased transfer payments, and unemployment benefits, and on the revenue side, tax revenues decrease because of decreased income. So, aggregate demand increases.
When there is an expansionary gap, government spending automatically decreases as transfer payments, and unemployment benefits decrease because of increased employment and welfare under economic expansion and on the revenue side, tax revenues increase because of increased income. So, aggregate demand decreases.

2) Spending multiplier:
Output gap/change in spending = 1/(1-MPC) = 1/(1-0.8) = 1/0.2
So, change in spending = output gap*(0.2) = (500)*(0.2) = 100 billion
So, government should increase spending by 100 billion

Tax multiplier:
Output gap/change in tax = -MPC/(1-MPC) = -0.8/(1-0.8) = -0.8/0.2 = -4
So, change in tac = output gap/(-4) = (500)(-4) = -125 billion
So, government should decrease tax by 125 billion