Question

21) Assuming the AD excess = $1770B and MPC = .74, complete the questions below. Please round to at least 2 decimal places. (Please answer in typed format, not hand written, due to trouble in interpretation of handwriting.)

a. (10 pts) Given the situation in a, if government spending decreases by $460B, calculate the impact to aggregate demand. Illustrate this scenario on the appropriate graph. QF and the shift that occurs must be included on the graph. Is there a GDP gap? If so, what type?

b. (10 pts) Given the situation in a, calculate what would happen if the government increases taxes by $460B. Illustrate this scenario on a separate graph. QF and the shift that occurs must be included on the graph. Is there a GDP gap? If so, what type?

c. (5 pts) Which type of government intervention (from scenarios A & B ABOVE) gets us closer to full employment output?

Answer 1

In each of the following graphs, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial equilibrium real GDP (Potential GDP) Y0. Current position of AD curve is at AD1 which intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, with positive GDP gap of (Y1 - Y0) (= $1770B).

(a) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.74) = 1 / 0.26 = 3.85

Decrease in AD ($B) = Decrease in government spending x Spending Multiplier = 460 x 3.85 = 1771

Since AD decreases by more than GDP gap, there is now a recessionary (negative GDP) gap equal to (1771 - 1770) = $1B.

In following graph, new position of AD curve is at AD2 which intersects SRAS0 at point B with lower price level P2 and lower real GDP Y2, with negative GDP gap of (Y0 - Y2) (= $1B).

(b) Tax multiplier = - MPC / (1 - MPC) = - 0.74 / 0.26 = - 2.85

Decrease in AD ($B) = Increase in tax x Tax Multiplier = 460 x 2.85 = 1311

Since AD decreases by less than GDP gap, there is still an inflationary (positive GDP) gap equal to (1770 - 1311) = $459B.

In following graph, new position of AD curve is at AD2 which intersects SRAS0 at point B with price level P2 and real GDP Y2, with positive GDP gap of (Y2 - Y0) (= $459B).

(c) Decrease in government spending gets us closer to full employment GDP (since GDP gap is lower).