Question

An economy is operating with output $300 billion above its natural level, and fiscal policymakers want to close this expansionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run.

To close the expansionary gap, the government would need to _________ (increase or decrease) spending by _____ billion.

Answer 1

The government will need to reduce spending by $60 billion

Step-by-step explanation:

Expansionary gap is defined as a situation where the total output of an economy exceeds its potential output. That is the economy is performing above its long term potential as measured by GDP.

When this occurs the government will need to reduce spending to match output with economic needs.

Marginal propensity to consume is the proportion of an individual's income that is reserved for consumption.

In this case it is 4/5. This means individuals are willing to spend 4/5 of their income on consumption

The amount needed by the economy to meet consumption is:

Amount consumed= (4/5) * 300 billion

Amount consumed= $240 billion

Therefore

Excess cash= 300 billion - 240 billion = $60 billion

The government will need to reduce spending by $60 billion