Question

Assuming the AD excess = $1330B and MPC = .85, complete the questions below. Please round to at least 2 decimal places.

a. (10 pts) Given the situation in a, if government spending decreases by $235B, 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 $235B.    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

Assuming the AD excess = $1330B and MPC = .85. This gives spending multiplier = 1/1-0.85 = 6.67. Tax multiplier = -MPC/1-MPC = -0.85/1-0.85 = -5.67

a) When Government spending is reduced by 235 B, GDP is increased by change in G x Multiplier = 235 x 6.67 = 1567.45. Now the GDP is decreased more than the excess demand gap so now there is a recessionary gap of (1330 - 1567.45) = 337.45 B

b) When taxes are increased by 235 B, GDP is increased by change in taxes x Multiplier = 235 x -5.67 = 1332.45. Now the GDP is still higher than full employment GDP but is very close to it. Excess AD is 1332.45 - 1330 = 2.45 B. This is an inflationary gap

c) Intervention in B is more helpful in getting us closer to full employment output. This is because the resultant GDP gap is now only 2.45 B.