Question

6. Should there be an inflationary gap of $3 trillion, what would Keynes think the government should do to return the economy to equilibrium with an MPS of 18%? Answer:

Answer 1

Answer 6

There is inflationary gap of $3 trillion. This means current output - Potential output = 3 trillion

Hence in order to reach long run equilibrium current output should equal to Potential output and hence current output should decrease by 3 trillion

At equilibrium Y = C + I + G + NX where C = Co + cY , where Co = Autonomous consumption and c = MPC = (1 - MPS) = 1 - 0.18 = 0.72

Hence Y = Co + 0.72Y + I + G + NX => Y - 0.72Y = Co + I + G + NX

=> Y = (1/0.18)(Co + I + G +NX) ------------------------ Current Equilibrium level of output

In order to decrease this current equilibrium level of output by 3 trillion G should change in such a way that change in Y = -3 trillion

=>

Hence In order return the economy to equilibrium, The Government should decrease its expenditure(G) by 0.54 trillion