Question

Assume that recession has occurred and real GDP is currently $250 billion less than the full employment level of real GDP The MPC is 0.80. Determine whether government spending should be increased or decreased, and by what amount, to retur the economy to full employment real GDP.

Answer 1

As there is a recession, so in order to get out of the recession, the government spending needs to increase.

Now, to determine the amount of government spending needs to increase in order to return the economy to full employment, we need to calculate the spending multiplier.

Spending Multiplier = 1 / (1 - MPC)

Here, MPC = 0.80.

So, Spending Multiplier = 1 / (1 - 0.80) = 5.

Now, we knew that,

Change in aggregate demand = Spending multiplier * Change in government spending.

Here, we need to increase the aggregate demand by $250 billion, in order to reach full employment real GDP.

So, $250 billion = 5 * Change in government spending

Change in government spending = ($250 / 5) billion = $50 billion.

So, we need to increase the government spending by $50 billion.

So, the government should increase the government spending by $50 billion in order to return to full employment real GDP.