Question

Using a SRAS, LRAS, AD model assume the following: full employment Real GDP is $18 trillion. At the present time, Real GDP is $18.3 trillion. The MPC is equal to .75. What kind of a gap exists and how large is that gap. If the government wanted to close that gap by changing G what kind of change and how much would the change in G have to be? If it wanted to close the gap by changing taxes, what and how much would the change in taxes have to be?

Answer 1

(a) Since real GDP is higher than full-employment GDP, there is an expansionary gap.

Expansionary gap ($ trillion) = Real GDP - Full-employment GDP = 18.3 - 18 = 0.3

(b) Government can close this gap by decreasing aggregate demand by lowering government spending.

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1/0.25 = 4

Decrease in G = Expansionary gap / Spending multiplier = $0.3 trillion / 4 = $0.075 trillion = $75 billion

(c) Government can close this gap by decreasing aggregate demand by increasing tax.

Tax multiplier = -MPC / (1 - MPC) = -0.75 / (1 - 0.75) = -0.75/0.25 = -3

Increase in Tax = Expansionary gap / Tax multiplier = $0.3 trillion / 3 = $0.1 trillion = $100 billion