Assume a simple closed Keynesian model where the MPC is 0.75 and the MPIM is 0.1
ID: 1116117 • Letter: A
Question
Assume a simple closed Keynesian model where the MPC is 0.75 and the MPIM is 0.15. Also assume that potential real GDP is $1000 million, while actual (equilibrium) real GDP is $700 million.
a. What is the GDP gap?
b. Is there an inflationary or recessionary gap?
c. What change in government spending is required to restore the economy to full
employment GDP? Show graphically using a Keynesian cross diagram.
d. What change in lump-sum taxes would bring about the same result?
e. Assume that a Balanced Budget Amendment is passed, so that increases in government spending must be accompanied by equal increases in lump-sum taxes. What change in both G and T will close the GDP gap? (HINT: What is the balanced budget multiplier in this model?)
Explanation / Answer
Assume a simple closed Keynesian model where the MPC is 0.75 and the MPIM is 0.15. Also assume that potential real GDP is $1000 million, while actual (equilibrium) real GDP is $700 million.
a) What is the GDP gap?
700 - 1000 = $300 million gap in the GDPs
b) Is there an inflationary or recessionary gap?
Since potential GDP is greater, it is a recessionary gap
c) What change in government spending is required to restore the economy to full employment GDP? Show graphically using a Keynesian cross diagram.
Since multiplier is = 1/1 - MPC + MPI = 1 / 1 - 0.75 + 0.15 = 2.5
To close the gap of 300 million, government spending will increase by 300/2.5 = $120 million
d) What change in lump-sum taxes would bring about the same result?
Tax multiplier is -MPC / 1 - MPC + MPI = -0.75/ 1 - 0.75 + 0.15 = -1.875
Required reduction in taxes is 300/1.875 = $160 million
e) BBM is 1. Hence a total of $300 million is needed to be the increase in both G and T that will close the gap
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