Question

If short-run equilibrium output equals 10,000, the income-expenditure multiplier equals 10, and potential output (Y*) equals 9,000, then government purchases must ______ to eliminate any output gap.

A. increase by 100
B. decrease by 100
C. increase by 1,000
D. decrease by 1,000

Answer 1

We need to decrease government spending by 100 to close an inflationary output gap when the multiplier is 10 and the desired reduction in output is 1,000 to match potential output.

Step-by-step explanation:

In this scenario, we have a situation where the short-run equilibrium output is greater than the potential output (Y*), indicating an inflationary gap. The current short-run equilibrium output (Y) is 10,000 and the potential output (Y*) is 9,000. The income-expenditure multiplier is given as 10. The output gap is the difference between the equilibrium output and the potential output, which is 10,000 - 9,000 = 1,000.

To close this inflationary gap, government spending (G) must be adjusted. An increase in G will have a multiplied effect on the output. However, since we already have an output that is too high, we need to decrease G. Since the multiplier is 10, to reduce the output by 1,000 (to bring it to the potential output level), we must decrease G by 1,000 / 10 = 100.

Therefore, government purchases must decrease by 100 to bring the economy back to its potential output and eliminate the output gap. The correct answer is B. decrease by 100.

Answer 2

Answer: Option (b) is correct.

Step-by-step explanation:

Given that,

short-run equilibrium output = 10,000

income-expenditure multiplier = 10

potential output (Y*) = 9,000

Expenditure multiplier =
`(1)/(1-slope\ of AE function)`

10 =
`(1)/(1-slope\ of AE function)`

Slope of AE function = 0.9

slope of AE = MPC (1-t) t =0,

MPC = 0.9

Delta Y (DY) = 1000

government expenditure multiplier ⇒
`(1)/(1 - MPC)` = 10

Delta G =
`(DY)/(government\ expenditure\ multiplier)`

=
`(1,000)/(10)`

= 100

Government purchases must be Decrease by 100.