Question

There is a recessionary gap, because at point A equilibrium real GDP of $18.5 trillion is...

There is a recessionary gap, because at point A equilibrium real GDP of $18.5 trillion is below the long-run level of $19 trillion. To eliminate the recessionary gap of $0.5 trillion, government spending must increase sufficiently to shift the AD curve rightward to a long-run equilibrium, which will entail a price level increase from 115 to 120.

If the marginal propensity to save equals 0.20 calculate the change in government spending that could eliminate the gap. (Round your answer to 2 decimal places)

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Answer #1

Elimination of recessionary gap can result in price level of 120.

At the initial level of aggregate demand, the aggregate demand corresponding to price level of 120 is $18 trillion.

The aggregate demand curve has to be shifted to right to achieve the long run level of real GDP of $19 trillion.

This means aggregate demand has to be increased by $1 trillion.

MPS = 0.20

Calculate the multiplier -

Multiplier = 1/MPS = 1/0.20 = 5

Calculate the increase in government spending -

Increase in government spending = Increase in aggregate demand/Multiplier = $1 trillion/5 = $0.20 billion

Thus,

The government spending should be increased by $0.20 billion to eliminate the recessionary gap.

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