Question

1. As an elected official, you have been informed that real GDP is below its potential and that action should be taken to encourage economic growth and bring the economy to its long-run equilibrium. The marginal propensity to consume is 0.6, and the amount of new government spending is $600 billion.

What is the multiplier? Compute this to the first place beyond the decimal.____________?

2. By how much would the economy be stimulated?

$ _________ billion

3.Suppose the economy is in a recession. The economy needs to expand by at least $400 billion, and the marginal propensity to consume is 0.7.

What is the least amount the government can spend to overcome the $400 billion gap?
$ ____________billion

4. The multiplier effect of fiscal policy predicts that an increase in government spending of $200 billion will increase total income by $1000.00 billion if the marginal propensity to consume is 0.80. If we account for crowding-out, then the increase in aggregate demand will be

Choose one:

A. exactly $1000.00 billion.

B. more than $1000.00 billion

C. less than $1000.00 billion.

Answer 1

1) MPC = 0.6

New Government Spending = $600 billion

Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.6)

= 2.5

2) Economy will increase by Government Spending * Multiplier

= $600 * 2.5 = $1,500 billion

3) If MPC is 0.7 and output gap is $400 billion

Multiplier = 1 / (1 - 0.7) = 3.33

If Government spend $X with multiplier 3.33 to cover $400 billion gap. X would be $120.12 billion

4) MPC = 0.8

Multiplier = 1 / (1 - MPC) = 1 / 0.2 = 5

If increase in government spending by $200 billion cause total income to increase by $1,000 billion which is the same effect dueb to multiplier 200 * 5 = 1,000. It means that there is no crowding out of investment in the economy.

Option A is correct.