Currently, a government\'s budget is balanced. The marginal propensity to consum

Question

Currently, a government's budget is balanced. The marginal propensity to consume is 0.80. 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.

Explanation / Answer

Multiplier (M) = 1/ 1-MPC

= 1/ 1-0.80

= 5

Total autonomous spending = 150/5 = $30 billion must increase in order to shift aggregate demand curve right by $150 billion.

Therefore if government increases it’s spending by $40 billion the market rate increases by 0.5%.

Hence, government should increase its expenditure by $40 billion.

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