Question

For a model economy, the mpc (marginal propensity to consume) is 0.8. Current GDP is $100 million. Potential GDP is $60 million. To reach full employment (reduce inflationary gap), government spending must g

Answer 1

To reach full employment (reduce inflationary gap), government spending must fall by $8 million.

Step-by-step explanation:

Multiplier = 1 / (1 - mpc) = 1 / (1 - 0.8) = 5

Output gap = Current GDP - Potential GDP = $100 - $60 = $40 million

Amount of change in government expenditure needed = Output gap / mpc = $40 / 5 = $8 million

Since the Potential GDP is less than the Current GDP, this implies that the government spending must fall by $8 million to reach full employment.

Therefore, to reach full employment (reduce inflationary gap), government spending must fall by $8 million.