Question

Current GDP is $13.5 trillion and full employment output (also known as potential GDP) is $16 trillion. If the MPC is .6 an initial injection of G would need to be ____ to successfully fill the gap, while an initial tax cut would need to be ____ to successfully fill the gap.

a. $1 trillion; approx. $600 billion b. $800 billion; also $800 billion
c. $800 billion; approx. $1.2 trillion d. $1 trillion; approx. $1.67 trillion

answer is D... I wanted to know why?

Answer 1

Answer
The GDP gap=potential GDP -actual GDP
=16-13.5
=2.5 trillion
To increase GDP government spending should be increased.
the increase=required GDP increase/multiplier
The multiplier =1/(1-MPC)
=1/(1-0.6)
=2.5
The required increase in GDP=2.5/2.5=1 trillion
--------------
the tax multiplier=-MPC/(1-MPC)
=-0.6/(1-0.6)
=-1.5
the required change in the tax = required increase in GDP/tax multiplier
=2.5/(-1.5)
=-1.67
the required decrease in tax is $1.67 trillion
Option D