Question

The U.S. economy and the world economy are in a recession caused by the COVID-19. Assume that the government increased its budget spending by 30 billion dollars and at the same time increased tax collection by 20 billion dollars. MPC is 0.8. by how much will GDP increase? What should the Fed do when the government increases its spending to help the economy recover from the recession? Use the AD and AS curves in your explanation.

Answer 1

Given that G rises by 30 b and taxes rise by 20 b

Spending multiplier is 1/(1-MPC) = 1/(1-0.8) = 5 and tax multiplier is -MPC/(1-MPC) = -0.8/0.2 = -4

GDP rises by 30 x 5 = 150b due to rise in G and falls by 20 x -4 = -80 b due to rise in taxes

Hence GDP rises finally by 150 - 80 = 70 billion

Fed should also accommodate and help the government by increasing the money supply. This shifts the AD to the right as the investment and then AD are higher when interest rate declines due to higher money supply