Question

1) An economy is facing a recession. The gap is $20 billion and the MPS is 0.1

A) Applying Keynesian (Demand-side) economics how much must the government change spending to close the gap - Be explicit - Show math work

B) If they chose to use a tax cut, what would they do? How much must the tax revenue change-show work

C) In both A and B, which curve will shift and in what direction?

2) What would supply-side economists recommend to close a gap?-Explain

3) If the aggregate supply curve shifts back, what happens to inflation and what is this type of inflation called.

Answer 1

Ans. Recessionary gap = $20 billion

MPS = 0.1

=> Marginal propensity to consume, MPC = 1-MPS = 1-0.1 = 0.9

=> Spending multiplier = 1/(1-c) = 1/(1-0.9) = 10

and Tax multiplier = -c/(1-c) = -0.9/(1-0.9) = -9

1A Recessionary gap = Spending multiplier * Change in government spending

=> 20 billion = 10*Change in government spending

=> Change in Government spending = $2 billion

Thus, government spending must increase by $2 billion

B. Recessionary gap = Tax multiplier * Change in Tax Revenue

=> 20 billion = -9 * Change in tax revenue

=> Change in tax revenue = -$2.22 billion

Thus, tax revenue must fall by $2.22 billion

C. In both the cases, the aggregate demand for goods and services increases shifting the aggregate demand curve to the right increasing the price level and filling the recessionary gap.

2. Supply side policies like fall in corporate tax rate, easing of regulations etc. will decrease the cost of production of the production units, so, they will increase production increasing the aggregate supply of goods and services.This increase in aggregate supply will shift the aggregate supply curve rightwards filling the recessionary gap but decreasing the price level and hence, inflation.

3. If the aggregate supply curve shifts back, the output level falls and price level rises. This increase in price causes inflation is called stagflation as the output is stagnant but inflation persist.

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