6. Suppose we are given the following information about the economy. Y = $12,000

Question

6. Suppose we are given the following information about the economy.
Y = $12,000 billion
Y* = $13,000 billion
The MPC = 0.6

a.Does the economy have a recessionary gap or an expansionary gap (i.e. inflationary gap)?


b.Suppose that the President is determined to have a full employment output. Assume also that Congress prefers to use changes in taxes as its fiscal policy tool. What is the specific change in taxes that Congress should impose on the public to accomplish the President’s wish? Be very specific providing both the exact dollar amount including whether this change in taxes should be positive (i.e. an increase) or negative (i.e. a decrease).

Explanation / Answer

a) As the potential output in the economy is only $12,000 billion and the actual output in the economy is $13,000 billion which is $1000 more. The economy is experiencing inflationary pressure i.e. inflationary gap.

b) MPC = 0.6 multiplier will be K = 1/1-MPC

= K = 1/1-0.6

= 1/0.4

= 2.5 THe spending multiplier in the economy is 2.5 i.e any change in the spending or increase in the tax will have 2.5 times affect the economy.

TO bridge a gap of 1000 billion the government will have to increase the tax by 1000/2.5 = 400 billion dollar in the economy.  

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