Question

Suppose that the MPC (Marginal Propensity to Consume) is 0.8, and there is a recessionary gap of $100 billion. Assuming a horizontal aggregate supply curve, how could Congress close this gap with fiscal policy? Provide the specific fiscal policy action in terms of increasing or decreasing taxes (T).

Answer 1

Congress can close a recessionary gap by using fiscal policy to decrease taxes, leveraging the multiplier effect associated with the MPC to increase aggregate expenditure and bring the economy back to potential GDP.

Step-by-step explanation:

To address a recessionary gap of $100 billion with the Marginal Propensity to Consume (MPC) at 0.8, Congress can use fiscal policy actions such as decreasing taxes or increasing government spending. By reducing taxes, the aggregate expenditure function shifts up, leading to a new equilibrium where the economy operates at potential GDP, thus closing the recessionary gap. This is due to the multiplier effect, where each dollar of tax reduction results in an $0.80 increase in consumption, which then circulates through the economy, ultimately leading to an increase in total expenditure by more than the initial stimulus.