Macro Policy: The level of real potential output in the United States in 2022 mi

Question

Macro Policy: The level of real potential output in the United States in 2022 might be $19 trillion, it might be $20 trillion, and it might be $21 trillion. Suppose that the Keynesian multiplier is 3, that private-spending flows are such that co+Io+NX = $4.5 trillion, and that even the most expansionary Federal Reserve policy cannot push the long-term risky real interest rate r below zero.

1. What should the government set real government purchases at in 2022 if potential GDP will be $19 trillion?

2. What should the government set real government purchases at in 2022 if potential GDP will be $20 trillion?

3. What should the government set real government purchases at in 2022 if potential GDP will be $21 trillion?

4. Suppose the government is uncertain about what the level of real potential GDP will be, but has to choose the level of government purchases in advance. Suppose further that the Federal Reserve does not have to set monetary policy until after the value for government purchases G has been chosen—and the Federal Reserve will not have to choose its monetary policy until after it learns what the level of potential output in 2022 will be. What level of G should the government choose?

5. In October 2015 Governor of the Federal Reserve Lael Brainard said: “The downside risks… argue against prematurely taking away the [low-interest rate] support that has been so critical…. These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize. The asymmetry in risk management stems from the combination of the likely low current level of the neutral real interest rate and the effective lower bound…. We have considerably greater latitude to adjust the path of policy in response to inflation that exceeds current forecasts than we have to provide additional accommodation in response to additional adverse [spending] shocks…” What is she saying here?

6. Why wasn’t your answer to (4): “A government uncertain about what the level of real potential GDP will be that has to choose the level of government purchases in advance should act as if real
potential output is relatively low and let the Federal Reserve take on the burden and lower interest rates if it learns that the level of potential output will be high”?

Explanation / Answer

GDP Gap = Potential GDP - Actual GDP

(1)

GDP gap = $(19 - 4.5) trillion = $14.5 trillion

Since multiplier is 3, as government spending (G) increases by $1, GDP increases by $3.

To increase GDP by $14.5 trillion, G is to increase by $14.5 trillion / 3 = $4.83 trillion

(2)

GDP gap = $(20 - 4.5) trillion = $15.5 trillion

Since multiplier is 3, as government spending (G) increases by $1, GDP increases by $3.

To increase GDP by $15.5 trillion, G is to increase by $15.5 trillion / 3 = $5.17 trillion

(3)

GDP gap = $(21 - 4.5) trillion = $16.5 trillion

Since multiplier is 3, as government spending (G) increases by $1, GDP increases by $3.

To increase GDP by $16.5 trillion, G is to increase by $16.5 trillion / 3 = $5.5 trillion

NOTE: First 3 questions are answered.

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