Suppose that real GDP is currently $17.1 trillio n, potential GDP is $17.4 trill

Question

Suppose that real GDP is currently $17.1 trillio n, potential GDP is $17.4 trillion, the government purchases multiplier is 2, and the tax multiplier i s -1.6.

• Holding other factors constant, by how much will go vernment purchases need to be increased to bring the economy to equilibrium at potential GD P?

• Holding other factors constant, by how much will ta xes need to be cut to bring the economy to equilibrium at potential GDP?

• What is an example of a combination of increase in government purchases and tax cuts that would have the desired effect of bringing the econo my to equilibrium at potential GDP?

Explanation / Answer

Consider the given problem, here “real GDP=17.1”, “potential GDP=17.4”, required change in “Y”, is “17.4-17.1 = 0.3 trillion”, dY=0.3.

1. Now, the govt. purchase multiplier is “2”, => dY/dG = 2, dG = dY/2 = 0.3/2 = 0.15 trillion.

=> G should increase by “0.15 trillion” to achieve potential level of GDP.

2. The tax multiplier is “-1.6”, => dY/dT = (-1.6), => dT = dY/(-1.6) = 0.3/(-1.6) = (-1.1875)trillion.

=> T should decrease by “-0.1875 trillion” to achieve potential level of GDP.

3. Now, from the NI identity we get, dY = 2*dG – 1.6*dT, where dY=0.3.

=> 0.3 = 2*dG – 1.6*dT. Now, assume that “G” increases by “0.07trillion” and “T” decreases by “0.1trillion”.

=> 2*dG -1.6*dT = 2*(0.07) – 1.6*(-0.1) = 0.14 + 0.16 = 0.3.

So, one example of increase in G and decrease in T to achieve potential GDP is dG=0.07 and dT=(-0.1).

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.