Part II 1-The government economists in a small country have determined that the

Question

Part II 1-The government economists in a small country have determined that the current equilibrium level of GDP at $350 billion is below the full employment GDP level of $410 billion. They further estimated a MPC of Q.60 for the households. They have proposed 3 actions the country's government can take to stabilize the economy. Use the info to ill in the blanks 1- Increasing government purchases by 2- Increasing transfer payments by 3- Lowering taxes by 700 600 500 400 AEo AE2 200 0 100 200 300 400 500 600 700 Real GDP Idollars) 2-In the graph above, the current equilibrium is based on AEo (aggregate expenditures) a- Suppose AE decreases What will be the $ GDP at the new equilibrium b- Suppose AE increases. What will be $ AE at the new equilibrium? c- What is the value of simple spending multiplier?(show how you got your answer)

Explanation / Answer

Question 1

Potential GDP is 410 while current GDP is 350 so there is a deflationary gap of 60

MPC is 0.60 so spending multiplier is 1/0.4 = 2.5 and tax multiplier is -0.6/0.4 = -1.5

If we increase government spending to close the gap, its size must be 60/2.5 = 24 . Transfer payments would not increase GDP. Taxes should be lowered by 60/1.5 = 40

Question 2

When AE shifts down, new GDP is determined by B which is 300. When AE shifts up, new GDP is determined by C which is 700. Note that GDP rises or falls by 200 while AE is increased by 80. Hence multiplier = 200/0.80 = 2.5.  

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