Question

Assume the United States economy has the following:

• GDP is $18,500 billion down from $19,350 billion nine months ago.
• Unemployment is at 7.8% up from 4.2% nine months ago.
• Inflation is stable at 2.0%.
• MPC=0.75
• NRU=4.0%
• Target Inflation is 2.0%

Required:
a. Explain in detail the problem the country is facing. Include an analysis of both inflation and unemployment including whether the economy is in a recession or not.
b. What is the size of the GDP gap? Show the calculations.
c. Government could address the problem with either increasing government spending, cutting taxes or both. If the government decided to increase spending to address the problem, by how much should spending be increased? If the government decided to cut taxes to address the problem, by how much should taxes be cut? Show the calculations and provide explanations.
d. Should the government cut taxes or increase spending or some combination of both to address the problem?
e. What could happen to make the policy you recommended?

Answer 1

Note: the e question is incomplete. The missing part is "you recommended in Question 4 ineffective?"

1. When the GDP has decreased, but the unemployment has increased, there is slowdown in the economy. Therefore, this slowdown combined with the stable inflation points that the economy is in recession.

2. GDP gap = Actual GDP - Potential GDP

GDP gap = $18,500 billion - $19,350 billion

GDP gap = -$850 billion

GDP gap is the difference between the actual and potential GDP.

3. Calculation of the government expenditure multiplier and tax multiplier

Government spending multiplier = 1 / (1-MPC)

Government spending multiplier = 1/(1-0.75)

Government spending multiplier = 1/0.25

Government spending multiplier = 4

Tax Multiplier = -MPC / (1-MPC)

Tax Multiplier = -0.75 / (1-0.75)

Tax Multiplier = -0.75 / 0.25

Tax Multiplier = -3

Calculation of the required increase in government spending

ΔG = ΔY/Government spending multiplier

ΔG = $850 billion / 4

ΔG = $212.5 billion

Calculation of the required cut in taxes

ΔY = Tax multiplier * ΔT

ΔT = ΔY / Government spending multiplier

ΔT = $850 billion / -3

ΔT = -$283.33 billion

Therefore, the government spending should increase by $212.5 billion and taxes should cut by $283.33 billion.

4. The government should opt for increasing government spending, this is because the government spending multiplier is greater than the tax multiplier.

5. If there is not direct impact on inflation after the increase in government spending