Question

A real Keynesian model of a mixed economy with a marginal propensity to consume equal to .9 produces an equilibrium level of $2400 billion that is $600 billion below a full employment level of output.

A) What change in government spending would bring about full employment? Be sure to calculate the government spending multiplier.

B) The resulting increase in real output have driven up real interests rates from 3% to 4% and those higher real interest rates reduced investment by $30 billion. Using IS/LM analysis illustrate the effect of your recommend change in government spending on the equilibrium level of output taking into account the effect of higher real interest rates on investment. Be sure to label the full multiplier and net multiplier effects. Then calculate the government spending multiplier and the net change in output and apply that number to your IS/LM diagram.

C) Yet further research indicates that the change in government spending also pushes up prices and the rise in prices reduces output by another $120 billion. Illustrate the effect of prices on output along with the effect of the crowding out of investment in a second IS/LM diagram. Be sure to label the multiplier effects before and after the rise in prices in the diagram as well as the level of output in each case.

D) Taking into account the reduction in investment in part B and the reduced output in part C, calculate what is now the net government multiplier. Then recommend a change in government spending that will just boost the level of output from $2400 billion to full employment.

(Your IS/LM diagrams should be neither particularly Keynesian nor Classical.)

Answer 1

1) goverment spending multiplier=1/(1-mpc)=1/(1-0.9)=1/0.1=10

Gdp gap=600

Required goverment spending Increases=600/10=60 billion

2) Decrease in gdp due to decrease in Investment=30*10=300 billion

Net Increase in gdp due to increase in government spending=600-300=300 billion

So net multiplier=300/60=5

C)

Increase in price Decreases real money supply leading to lefttwards shift of LM curve .

D)New goverment spending multiplier=(2580-2400)/60=180/60=3

So Actual required Increase in government spending=600/3=200 billion