Question

Assuming the AD shortfall = $1880B and MPC = .71, complete the questions below. Please round to at least 2 decimal places.

a. Given the situation in a, if government spending increases by $768B, calculate the impact to aggregate demand. Illustrate this scenario on the appropriate graph. QF and the shift that occurs must be included on the graph. Is there a GDP gap? If so, what type?

b. Given the situation in a, calculate what would happen if the government cut taxes by $768B.    Illustrate this scenario on a separate graph. QF and the shift that occurs must be included on the graph. Is there a GDP gap? If so, what type?

c. Which type of government intervention (from scenarios A & B ABOVE) gets us closer to full employment output?

Answer 1

In both graphs, long run equilibrium is at point A where AD0, LRAS0 and SRAS0 intersect with long-run equilibrium price level P0 and long-run (potential) GDP Y0. Due to shortfall in aggregate demand, current position of AD is at AD1 where price level is lower at P1 and real GDP is lower at Y1, so recessionary gap (shortfall) equals (Y0 - Y1).

(a) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.71) = 1 / 0.29 = 3.45

Increase in aggregate demand ($B) = Increase in government spending x Multiplier = 768 x 3.45 = 2,649.60

Since increase in AD is higher than the shortfall in AD, there is an inflationary gap equal to $(2,649.6 - 1,880)B = $769.60B.

In following graph, AD will shift rightward to AD1, intersecting SRAS0 at point C where price level is further higher at P2 and real GDP Y2 is higher than potential GDP. An inflationary gap equal to (Y2 - Y0) is created.

(a) Tax multiplier = - MPC / (1 - MPC) = - 0.71 / (1 - 0.71) = - 0.71 / 0.29 = - 2.45

Increase in aggregate demand ($B) = Decrease in tax x Multiplier = 768 x 2.45 = 1,881.60

Since increase in AD is slightly than the shortfall in AD, there is an inflationary gap equal to $(1,881.60 - 1,880)B = $1.60B.

In following graph, AD will shift rightward to AD1, intersecting SRAS0 at point C where price level is further higher at P2 and real GDP Y2 is higher than potential GDP. An inflationary gap equal to (Y2 - Y0) is created.

(c) A tax cut of $768 creates a lower magnitude of inflationary gap compared to an increase in government spending, so the tax cut policy gets the economy closer to full employment output (potential GDP).