Discretionary fiscal policy and multiplier effects Consider a hypothetical close

Question

Discretionary fiscal policy and multiplier effects Consider a hypothetical closed economy in which the marginal propensity to consume (MPC) is 0.5 and taxes do not vary with income (that is, taxes are fixed rather than variable and the income tax rate t = 0). The following graph shows the aggregate demand curves (AD_1 and AD_2), the short-run aggregate supply (AS) curve, and the long-run aggregate supply curve at the potential GDP level. The economy is currently at point A. The economy is currently experiencing gap of billion. To close this gap, one option would be for the government to government purchases by billion (assuming net taxes do not change). If the government kept its purchases constant, it could also close the gap by net taxes (taxes minus transfers) by billion.

Explanation / Answer

The economy is currently experiencing a recessionary gap of $200 billion i.e. $100 billion of real GDP and $4 of the price level. This is because point A is on the left-hand side of potential GDP.

To close this gap, one option would be for the government to increase government purchases by $200 billion. This is because, since MPC is 0.5, the multiplier will be equal to MPC/1-MPC = 2. So, an increase in government purchases by $200 billion would increase nominal GDP by $400 billion.

If the government kept its purchases constant, it could also close the gap by reducing net taxes by $400 billion as the multiplier in this case is -MPC/MPS = -0.5/0.5 = -1

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