Currently a government budget is balanced. The marginal propensity to consume is

Question

Currently a government budget is balanced. The marginal propensity to consume is 0.75. The government has determined that each additional $10 billion in new government debt it issues to finance a budget deficit pushes up the market interest by 0.10 percentage points. It has also determined that every 0.10 (one-tenth) percentage point change in the market interest rate generates a change in planned investment expenditures equal to $2 billion. finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to $250 billion. Assuming that there are no direct expenditure offsets to fiscal policy, calculate the increase in government expenditures. (hint: how much private investment spending will each $10 billion increase in government spending crowd out?) Round answer to two decimal points.

Explanation / Answer

Increase in 1 Billion expenditure by the government reduces the $ 0.20 Billion expenditure by the private sector.

Net Change = 1- 0.20

= 0.80

Investment multiplier = 1/1-MPC

= 1/1-0.75

= 1/0.25

= 4

Net Multiplier = 0.80 /0.25

= 3.2

Expenditure needed to plug recessionary gap:

EX * 3.2 = 250

EX = 250 / 3.2

= 78.12

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