Question

suppose actual real gdp is $10.31 trillion, potential real gdp is $6.67 trillion, and the marginal propensity to consume is 0.73. if we ignore price effects, and if the government already decided to increase its spending by $1.36 trillion, by how many trillions of dollars should the government change its lump sum taxes to fix the gap? (round this to two digits after the decimal and enter this value as either a positive value or a negative value without the dollar sign.)

Answer 1

To close the inflationary gap between the actual and potential real GDP, with a marginal propensity to consume of 0.73 and an initial government spending increase of $1.36 trillion, the government should change its lump sum taxes by -$0.38 trillion (or increase taxes by $0.38 trillion).

Step-by-step explanation:

In the context of Keynesian economics, when actual real GDP exceeds potential real GDP, there is an inflationary gap. To address this, the government can use fiscal policy to adjust government spending and taxes to return the economy to its potential output without causing inflation. With an actual real GDP of $10.31 trillion and a potential real GDP of $6.67 trillion, there is a positive gap of $3.64 trillion. Given the marginal propensity to consume (MPC) is 0.73, the multiplier is calculated using the formula 1/(1-MPC), which is 1/(1-0.73) = 3.7. The government decided to increase its spending by $1.36 trillion, already utilizing the multiplier effect.

The new equilibrium level of GDP after the increase in government spending can be found by multiplying the multiplier with the change in government spending. This gives us a change in real GDP of $1.36 trillion * 3.7 = $5.032 trillion. Since the goal is to close the gap between actual and potential GDP, we look at how much taxes should change to bring the actual GDP down to the potential level, considering the multiplier effect.

To find out how much the government should change its lump sum taxes, we need to calculate the remaining gap after the initial spending increase. The remaining gap is $3.64 trillion - $5.032 trillion (because the spending increase overcorrected the gap). To close this new gap with taxation, consider the inverse of the multiplier: change in taxes = (remaining gap / multiplier). The formula yields change in taxes = (-$1.392 trillion / 3.7) = -$0.38 trillion. Therefore, the government should change its lump sum taxes by -$0.38 trillion (or increase taxes by $0.38 trillion) to bring the economy back to potential output.