Suppose the economy is initially in long-run equilibrium at a potential output o

Question

Suppose the economy is initially in long-run equilibrium at a potential output of 12.5 trillion. Now suppose that aggregate demand shifts back to AD’. How much of a gap has opened between actual output and potential output? Is this an expansionary or contractionary gap?

Suppose that the MPC = 0.86, how much would the government need to change spending to close this gap? Would they increase or decrease spending?

Suppose again that the MPC = 0.86, how much would the government need to change net taxes to close this gap? Would they increase or decrease taxes?

Briefly describe two drawbacks associated with fiscal policy of this type?

Explanation / Answer

1. Gap opened between actual output and potential output = Potential - actual output = 12.5 - 10.4 = 2.1 trillion

  It's a contractionary Policy

2. MPC = 0.86

Government spending Multiplier = = 1/MPS = 1/1 MPC

So Change in Output = Government spending Multiplier * change in Government spending

Change in Output = 1/1-MPC *change in Government spending

change in Government spending = (1-MPC)Change in Output

   = 1/(1 - 0.86)*2.1

   = 0.294 trillion

So, Government has to increase spending by  0.294 trillion to close this gap.

c.

  Tax Multiplier =MPC/MPS = MPC/1 MPC

So Change in Output = Tax Multiplier* change in net taxes

2.1 = 0.86/0.14*change in net taxes

change in net taxes = 2.1*0.14/0.86 = 0.3419 trillion

So net taxes should decrease by 0.3419 trillion

The two drawbacks of this olicy are

1. It leads to increased unemployment. In order to slow down production and raise interest rates, companies do not hire new employees. The demand for labor is reduced, prices decline, people have less money, therefore, consequently, employment sees a reduction.
2. It reduces economic growth since there is reduced supply of money. Reduced prices, less demand, etc., leads to stunted economic growth.

If you don't understand anything then comment , I'ill revert back on the same..:)

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