Question

Using Fiscal Policy, if there is a gap, provide the change(s) required to eliminate any output gap (don’t forget to consider the multiplier) Cchange only one component at a time – do not use a combination of changes – but consider all possible options. (Formula for multiplier:     Multiplier =( )

a) what is the multiplier?

b) what are the change(s) using fiscal policy to close output gap?

Answer 1

There are below two options in Fiscal Policy to close an output gap:

- Change in government spending

- Change in taxes

Ther can be two possible output gaps:

- Recessionary Gap: where actual output < potential output

- Inflationary Gap: where actual output > potential output

Government Expenditure Multiplier = 1 / (1 - MPC)

where MPC = marginal propensity to consume

Tax multiplier = MPC / (1 - MPC)

a) a multiplier is the economic factor which impacts other economic variables when changed.

b)

If there is recessionary gap, then an Expansionary Fiscal Policy is required. There should be either increase in government spending or reduction in the taxes.

Government should increase in the spending based on below formula:

Increase in G = Size of Recessionay Gap / Spending Multiplier

Similarly, if there is recessionary gap, then either government spending needs to be reduced or increase in taxes are required. Such policy is called Contractionary Fiscal Policy.

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