3. Discretionary fiscal policy and multiplier effects Aa Aa Consider a hypotheti

Question

3. Discretionary fiscal policy and multiplier effects Aa Aa Consider a hypothetical economy in which the marginal propensity to consume (MPC) is 0.8. The following graph shows the aggregate demand curves (AD1 and AD2), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply curve (LRAS). The economy is currently at point A. PRICE LEVEL 140 136 132 128 124 120 116 112 108 LRAS SRAS124 AD2 AD 500 600 700 800 900 1000 1100 1200 1300 REAL GDP (Billions of dollars) The economy is currently experiencing a recessionary gap of $50 billion In order to close this gap, one option would be for the government to increasegovernment purchases by $80 billion (assuming net taxes do not change If the government kept its purchases constant, it could also close the gap by net taxes by

Explanation / Answer

when the outputs is less than the full employment level of output it is called rrcessionary gap

here the economy is facing same situation thus we can say there is a recessionary gap and here it is of 100

in order to close the gap the government should increase the government purchases by 100/multiplier value

= 100 / 1/1-0.8 = 20 billion

now tax multiplier is gievn by MPC / MPS = 0.8/0.2 = 4

SO IT TAXES HAS TO BE USED THAN TAXES NEEDS TO BE DECREASED BY 100/4 = 25 BILLION

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