Question

Suppose an economy is producing real GDP of $300 billion. The potential output is equal to $400 billion, and the MPC is equal to 0.80. Then the government should follow a policy of:

Answer 1

Government should use expansionary policy to increase spending by $20 billion or decrease taxes by $25 billion or use a balanced budget policy of increasing taxes and spending by $100 billion.

Step-by-step explanation:

GDP gap = Real potential GDP -actual real GDP = $400 billion - $300 billion = $100 billion

Multiplier = 1/(1-MPC) = 1/(1-0.8) =5 . The required change in spending to eliminate gap = Gap/multiplier = $100 billion / 5 = $20 billion

Tax multiplier = -MPC / (1-MPC) = -0.8/(1-0.8) = -4

Points are: The required change in taxes to eliminate =100/(-4) = -$25, the minus sign shows a decrease , the tax should be decreased by $25