Question

Use the aggregate expenditures model and assume an economy is in equilibrium at $5 trillion which is $250 billion below full-employment GDP. If the marginal propensity to consume (MPC) is 0.60, full-employment GDP can be reached if government spending:

Answer 1

Government must reduce spending by 100 billion to reach full employment

Step-by-step explanation:

First, let plug in the MPC to find the spending multiplier

Spending Multiplier = 1 / 1 - MPC

Spending Multiplier = 1 / 1-0.6

Spending Multiplier = 1 / 0.4

Spending Multiplier = 2.5

We also know that we are looking to change the equilibrium output (Y) by -250 billion

ΔG * Multiplier = ΔY / Multiplier

= -250 billion / 2.5

= -100 billion

Therefore, government must reduce spending by 100 billion to reach full employment