Question

he current equilibrium level of income for a nation is $4,000 billion. The full employment level of income is $7,000 billion. The MPC is 0.80. The current level of Investment is $1200 billion. The current level of government spending is $1600 billion.

Develop two different policies to move this economy to be in equilibrium at full employment. Clearly explain and/or show exactly (including using numbers) what the two plans are and how you developed them.  

(a) Plan 1

(b) Plan 2

Answer 1

Negative GDP gap ($B) = Potential GDP - Actual GDP = 7,000 - 4,000 = 3,000

This gap can be closed by (1) Increasing government spending (G) or (2) Decreasing tax (T).

(a) Plan 1

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1/0.2 = 5

Increase in G ($B) = Negative GDP gap / Spending multiplier = 3,000 / 5 = 600

(b) Plan 2

Tax multiplier = - MPC / (1 - MPC) = - 0.8/0.2 = - 4

Decrease in T ($B) = Negative GDP gap / Absolute value of Tax multiplier = 3,000 / 4 = 750