Question

You are given the following information about aggregate demand at the existing price level for an economy: (1) consumption = $500 billion, (2) investment = $50 billion, (3) government purchases =$100 billion, and (4) exports =$20 billion, imports = $40 billion. If the full-employment level of GDP for this economy is $700 billion. Marginal Propensity to Consume (MPC) of the economy is 0.5. What action would be mosst consistent with closing the GDP-gap here? Explain your answer, and show your calculation.

Answer 1

AD= Consumption+ Investment+ Government purchase+ Exports-Imports

AD= 500+50+100+20-50= $ 630 billion

In Equilibrium, GDP=AD

Therefore, Current GDP in the Economy= $630 billion

Full Employment level of GDP= $700.

There is a Recessionary Gap of $70 billion (=$700 billion–$630 billion).

Expansionary Fiscal Policy would be most consistent action to close the GDP gap.

Government Purchases have to be increased.

Government Spending Multiplier= 1/(1-MPC)= 1/(1-0.5)= 2.

Increase in Government purchase required to close output Gap= Required Increase in GDP/Government Spending Multiplier

Increase in Government Purchases required to close the GDP= $70 billion/2= $35 billion.

Therefore, Government Purchases would be increased by $35 billion to close the GDP gap.