Currently, a government\'s budget is balanced. The marginal propensity to consum
ID: 1165149 • Letter: C
Question
Currently, a government's 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 rate by 0.20 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 $4 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 $150 billion. Assuming that there are no direct expenditure offsets to fiscal policy, calculate the increase in government expenditures necessary to close the recessionary gap. (Hint: How much private investment spending will each $10 billion increase in government spending crowd out?) $billion. (Enter your response rounded to two decimal places.)Explanation / Answer
We know that if government expenditure is increased by $4 billion, planned investment expenditure falls by $mx=$0.4 billion (4 billion x 0.10). Thus, for each $1 billion increase in government spending, there is a net change in initial spending of:
(1-mx) = (1 – 0.4) = $0.6
We also know that the aggregate demand curve will shift to the right by the net change in spending multiplied by the multiplier, which
= 1 / (1- MPC) = 10
= 1 / (1 – 0.75) = 10
Therefore, the net increase in AD due to the $1 billion increase in government expenditure is
= (1 - mx) / (1 - MPC) = 6 which is the net multiplier.
To close the recessionary gap, government spending will have to increase by an amount equal to: Recessionary gap / net multiplier = 150 / 6 = $25 billion
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