Question

In: Economics

An economy is initially at full employment, but a decrease inplanned investment spending pushes the...

An economy is initially at full employment, but a decrease in planned investment spending pushes the economy into recession. Assume that the MPC of this economy is .50 and that the multiplier is 2.00.

  1. How large is the recessionary gap after the fall in planned investment?


  1. By how much would the government have to change its purchases to restore the government to full employment?


  1. Alternatively, by how much would the government have to change taxes?

Solutions

Expert Solution

a) Suppose desired investment falls by D, then the decrease in output is multiplier(m) times the fall in desired investment i.e. m*D or 2D. So, the recessionary gap is 2D.

b) To increase output back to full employment level, the government will need to increase government spending by,

G = Recessionary gap/ multiplier = 2D/2 = D

So, increase in government expenditure by D will move back output to full employment level.

c) Tax multiplier, t = MPC/(1-MPC) = 0.5/(1-0.5) = 1

So, decrease in taxes to fill the recessionary gap = Recessionary gap/ Tax multiplier = 2D/t = 2D/1.

So, decrease in tax required to increase output to full employment level is 2D.

Rahul Sunny answered 2 years ago
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