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Suppose the economy is in long-run equilibrium when GDP declines by $50 billion. The government wants...

Suppose the economy is in long-run equilibrium when GDP declines by $50 billion. The government wants to increase its spending in order to stimulate the economy and avoid a recession. Assume that the crowding-out effect is always half as strong as the multiplier effect, and the MPC equals 0.9. According to Keynesian theory, how much additional government spending is needed to restore economic output?

$10 billion
$45 billion
$50 billion
$100 billion
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Answer #1

Initially the economy is at long-run equilibrium. Now GDP declines by $50 billion. This is the recessionary gap created as a result. Given that the crowding-out effect is always half as strong as the multiplier effect, and the MPC equals 0.9 we find that spending multiplier is 1/1-MPC = 1/1-0.9 = 10. Now crowding out effect has to be taken care off. With crowding out, the amount of government spending increase is equal to GDP gap / multiplier = 50/10 = $5 billion.

Now with crowding out makes multiplier effect reduced to half of its value, new multiplier is 5. Hence the additional government spending needed to restore economic output is 50/5 = $10 billion.

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