Assume the economy is in a recession. The government elects to use direct expend

Question

Assume the economy is in a recession. The government elects to use direct expenditures to try to close the recessionary gap. It knows that the recessionary gap equals $500 billion. It also knows the marginal propensity to consume equals 0.80. Finally, it knows that the AD shortfall is two times as large as the gap. Given his information, the government will need to spend ________ in order to entirely eliminate the recessionary gap.

$100 billion

$50 billion

$200 billion

$500 billion

$100 billion

$50 billion

$200 billion

$500 billion

Explanation / Answer

Correct option is (1).

To close recessionary gap, real GDP has to increase by the amount of recessionary gap, i.e. by $500 billion.

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

This means that, if government spending increases by $1, real GDP will increase by $5.

To increase real GDP by $500 billion, required increase in government spending = $500 billion / 5 = $100 billion

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