Question

Fixing a Gap

If the average Canadian would spend $190 of a $950 raise in salary, and assume we are currently facing a small $25 Billion inflationary gap, then:

a)   Find the MPC, the MPS, the Tax multiplier (TM) and the Spending Multiplier (SM).

b)   By how much would the government need to change taxes to get rid of the Gap?

c)   In this scenario, is fiscal policy being effective (Meaning is it working well)? Clearly explain why or why not.

d)   If instead the BoC got involved, what kind of monetary policy would they use to eliminate the Gap? Explain how the BoC would do this.

e)   Which policy (Fiscal or Monetary) would have been best to use in your opinion? Clearly explain your answer.

Answer 1

Inflationary gap = $25 billion

a) MPC = Change in consumption / Change in Income

Change in consumption = $190

Change in Income = $950

MPC = 190 / 950 = 0.2

As MPC + MPS = 1

MPS = 0.8

Tax Multiplier = MPC / MPS = 0.2 / 0.8 = 0.25

Spending Multiplier = [1 / (1 - MPC)] = [1 / (1 - 0.2)] = 1.25

b) To reduce the gap, government need to raise taxes by $100 billion because Change in Taxes * Tax Multiplier = Inflatonary Gap

Change in Taxes * 0.25 = 25

Change in Taxes = 100

c) Government have to reduce tax by $100 billion to remove inflationary gap which means that it is costing very high to government or they can reduce government spending to make it more effective rather than raising taxes.

d) If BoC got involved, they should adopt contractionary monetary policy which will reduce the circulation of money in the economy which eventually tends to reduce the aggregate demand in the economy.

e) If BoC can reduce the aggregate demand, as per spending multiplier they can reduce inflationary gap by educing $20 billion of aggregate demand because Change in Aggregate demand * Spending Multiplier = Inflationary Gap

Change in Aggregate demand * 1.25 = 25

Change in Aggregate demand = 20

We can say that BoC monetary policy is more effecive in this case because fiscal policy cost $100 billion to reduce inflationary gap which is five times more than the fall in aggregate demand.