Question

The economy of Newland is in short-run macroeconomic equilibrium. The current real output is $400 billion, and the full employment output is $500 billion. The marginal propensity to consume is 0.8.

(a) Is the economy experiencing a recessionary output gap or an inflationary output gap? Explain.

(b) Assume Newland’s government is considering taking action to close the output gap identified in part (a).

(i) Calculate the minimum change and indicate the direction of change in government spending required to shift the aggregate demand curve to close the output gap.  Show your work.

(ii) If instead Newland’s government changes taxes without changing government spending, calculate the minimum change and indicate the direction of change in taxes required to shift the aggregate demand curve to close the output gap.  Show your work.

(c) Which fiscal policy action, changing government spending or changing taxes, is more effective in closing the output gap? Explain.

(d) Assume instead Newland’s government decides not to take any policy action. Will short-run aggregate supply increase, decrease, or stay the same in the long run? Explain.

Answer 1

Given,

The economy of Newland is in short-run macroeconomic equilibrium.

The current real output is $400 billion, and the full employment output is $500 billion.

The marginal propensity to consume is 0.8.

(a) Is the economy experiencing a recessionary output gap or an inflationary output gap? Explain.

The economy is experiencing a recessionary output gap.

This is because current output is less than potential. The diagram below shows this:

(b) Assume Newland’s government is considering taking action to close the output gap identified in part (a).

(i) Calculate the minimum change and indicate the direction of change in government spending required to shift the aggregate demand curve to close the output gap.  Show your work.

MPC = 0.8

Thus multiplier

Output gap = $100 billion

Thus government expenditures have to be increased by $20 billion to shift the AD curve to the right, and close the gap.

(ii) If instead Newland’s government changes taxes without changing government spending, calculate the minimum change and indicate the direction of change in taxes required to shift the aggregate demand curve to close the output gap.  Show your work.

Taxes have to be decreased by $20 billion to shift the AD curve to the right, and close the gap. This is applicable if taxes are lump sum in nature.

If tax-rates are applicable, they have to be reduced to induce autonomous components like C and I to increase collectively by $20 billion. For this, information on tax rates is needed.

(c) Which fiscal policy action, changing government spending or changing taxes, is more effective in closing the output gap? Explain.

Increasing government expenditures is considered to be more effective than reducing taxes.

Increased G has a direct and immediate effect on AD, without much lags. Tax changes have a lag of a few months.

Increased G directly gets multiplied with the multiplier (m). Tax changes, which are generally rate based, have their own tax multiplier. It is

This reduces the positive effect on GDP.

The main problem is, how to structure a tax policy that gives the exact desired result (for eg. $100 billion increase in GDP).

(d) Assume instead Newland’s government decides not to take any policy action. Will short-run aggregate supply increase, decrease, or stay the same in the long run? Explain.

If the government doesn't intervene, and the recessionary gap continues, the SRAS will self-adjust.

As price levels are lower, the nominal wages will also fall. However, firms don't change selling price easily. With lower cost of production, the SRAS will shift to the right, and new equilibrium quantity will be at the LRAS level.

The final price level will be lower than earlier. This is shown below: