Question

In: Economics

. Assume a simple closed Keynesian model where the MPC is 0.9 and the MPIM is...

. Assume a simple closed Keynesian model where the MPC is 0.9 and the MPIM is 0.1. Also assume that potential real GDP is $2000 million, while actual (equilibrium) real GDP is $1200 million.

            a. What is the GDP gap?

            b. Is there an inflationary or recessionary gap?

            c. What change in government spending is required to restore the economy to full

                employment GDP? Show graphically using a Keynesian cross diagram.

d. What change in lump-sum taxes would bring about the same result?

e. Now assume that a Balanced Budget Amendment is passed, so that increases in

     government spending must be accompanied by equal increases in lump-sum

     taxes. What change in both G and T will close the GDP gap? (HINT: What is

     the balanced budget multiplier in this model?)

Solutions

Expert Solution

(a)GDP gap = Potential GDP - Actual GDP = $(2000 - 1200) million = $800 million

(b)Since GDP gap is positive, this is a recessionary gap.

(c)Spending multiplier = 1 / (1 - MPC + MPIM) = 1 / (1 - 0.9 + 0.1) = 1 / 0.2 = 5

This means, if government spending rises by $1, real GDP rises by $5.

To increase real GDP by $800 million, government spending has to rise by ($800 million / 5) = $160 million.

In following graph, economy is at point B where a recessionary gap equal to (Y0 - Y1). As the government spending rises, equilibrium point moves from point B to point A where planned aggregate expenditure (PAE) curve intersects the 450 line, with real GDP being restored to potential GDP of Y0, eliminating the recessionary gap.

(d)Tax multiplier = - MPC / (1 - MPC + MPIM) = - 0.9 / 0.2 = - 4.5

It means, if tax is cut by $1, GDP rises by $4.5.

To increase GDP by $800 million, tax should be cut by ($800 million / 4.5) = $177.77 million.

NOTE: First 4 parts are answered.


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