Final answer:
The economy's problem relating to full employment equilibrium (yf) may either be an inflationary or a recessionary gap. To correct this, the government can modify taxes or government spending to influence aggregate demand and aim for the full employment equilibrium.
Step-by-step explanation:
When trying to determine what problem the economy is facing given a full employment equilibrium (yf) of $2 trillion per year, we need to solve for the equilibrium level of output (Ye). The spending desires of market participants are consumption (C) at $400 billion plus 0.5 of disposable income (Yd), investment (I) at $300 billion, and government spending (G) at $400 billion. To find the equilibrium output (Y), we typically use the formula Y = C + I + G. However, to find Ye, we need to include T (taxes) and calculate disposable income as Y - T, with C becoming $400 billion + 0.5(Y - T).
If we consider C + I + G greater than or equal to yf, there might be an inflationary gap – that is where aggregate spending is higher than the full employment output, leading to rising prices. If C + I + G is less than yf, we may have a recessionary gap where aggregate demand is insufficient to purchase the full employment level of output, resulting in unemployment.To address these issues, the government can adjust either taxes or government spending. A change in taxes alters disposable income and therefore consumption, while a change in government spending directly affects aggregate demand. For instance, if the economy needs stimulation, the government could reduce taxes or increase spending, which would increase disposable income or aggregate demand respectively. On the contrary, if inflation is a concern, increasing taxes or cutting government spending would be practical measures.