Question

If LRAS = $500 billion, RGDP = $700 billion, and MPC = .8, then what should the government do under fiscal policy? Be specific. Also draw and label both the current situation and what would occur as the government impacted the economy through their actions.

Answer 1

Answer -

Output Gap = 700-500

= $ 200

This is inflationary gap

Spending multiplier = 1(1-MPC)

= 1/(1-0.8)

= 1/0.2

= 5

The government should decrease the spending by (200/5) = $ 40 billion in order to reduce the inflationary gap of $ 200 billion in economy. Tax multiplier will be 4 . Hence government can also raise the taxes by $ 50 billion in order to close this inflationary gap. The AS will shift left closing this inflationary gap. This is because Fiscal contractionary policy is more kind of Supply side policy as per Keynesian approch.