Question

1. During a recessionary gap, is the goal to increase or decrease the equilibrium

      GDP?  Will the change in spending be greater than, less than or equal to the

      change in the equilibrium GDP?

2. In a given economy, with an equilibrium GDP of $750,000 both governmen

    purchases and taxes increase by $50,000.  Solve for the new equilibrium GDP that

    will result from these two changes.

3. In a given economy with an MPC of 0.8, the equilibrium GDP equals $600,000.  

      If M increases by $20000, solve for the new equilibrium GDP that will result.

Answer 1

Part 1) During a recessionary gap the actual gross domestic product (GDP) is less than the full employment/potential GDP. So, the goal is to increase the equilibrium GDP through expansionary monetary or expansionary fiscal policies. Due to the presence of spending multiplier the required change in spending will be less than the change in the equilibrium GDP. This is because the GDP increases initially directly by the change in spending and then indirectly through the multiplier effect as change in spending causes change in consumption.

Part 2) It is given that the equilibrium GDP is $750,000.

Now both government purchases and taxes have been increased by $50,000. So, the change in the GDP will rise by $50,000. The new GDP will be $800,000. This happens because when government purchases and taxes are increased by the same amount, then it is a situation of balanced budget multiplier whose value is 1.

Reason for this is that in the case of government purchases the GDP is initially increased directly by the amount of increase in government purchases and then indirectly through the multiplier effect. On the other hand, changes in taxes will affect the GDP only when its impact on the disposable income affects the consumption expenditure. So, even after increase in taxes there is no impact on the consumption then the impact of tax reduction on the GDP will be minimal.

Part 3) We have the following information

Marginal propensity to consume (MPC) = 0.8

Multiplier = 1/(1 – MPC) = 1/(1 – 0.8) = 5

Change in GDP = Multiplier × Change in M

Change in GDP = 5 × 20,000

Change in GDP = $100,000

So, the GDP increases by $100,000. New GDP = $700,000