Question

1. Draw an AD-AS model depicting an economy with a recessionary gap in the short-run due to dramatic decline in net exports.
2. Assume the full potential real GDP in the economy is 20 and that actual real GDP is 10. If the multiplier is equal to 2 what amount of government spending would eliminate the recessionary gap? Depict the effect of an increase in government spending on your AD-AS graph.
3. If the multiplier is equal to 2, what is the marginal propensity to consume equal to? Describe the marginal propensity to consume.

Answer 1

(a)

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect, with equilibrium price level P0 and real GDP (= Potential GDP) Y0. However, due to recessionary gap, aggregate demand is lower and current positive of economy is at point B where AD1 intersects SRAS0, with lower price level P1 and lower real GDP Y1, with recessionary gap being (Y0 - Y1).

(b)

Recessionary gap = Potential GDP - Actual GDP = 20 - 10 = 10

To close the gap, aggregate demand has to be increased by increasing government spending.

Increase in government spending = Recessionary gap / Multiplier = 10 / 2 = 5

In above graph, this will increase aggregate demand, shifting AD1 rightward to AD0, restoring initial long run equilibrium.

(c)

Multiplier = 1 / (1 - MPC)

2 = 1 / (1 - MPC)

1 - MPC = 1/2 = 0.5

MPC = 1 - 0.5 = 0.5

MPC of 0.5 means that when disposable income increases by 1 unit, consumption increases by 0.5 units.