Question

Currently, a government's budget is balanced. The marginal propensity to consume is 0.80. The government has determined that each additional $10 Billion in new government debt it issues to finance a budget deficit pushes up the market interest rate by 0.1 percentage point. It has also determined that every 0.1 percentage point change in the market interest rate generates a change in investment expenditures equal to $2 Billion. Finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to $200 Billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase its expenditures to eliminate a recessionary gap of $200 Billion? Please explain and show your calculations. (20 points)

Answer 1