6. Suppose the reserve ratio in Misery-Land has been set at 5%. Consumers in Mis

Question

6. Suppose the reserve ratio in Misery-Land has been set at 5%. Consumers in Misery-Land earn an average of $15,000 per month from January to December of 2004. Consumers deposit their savings in the banks, and each consumer deposits a yearly average of $40,000. The economy is currently experiencing an inflationary gap of $600 million. a. Using government expenditure, correct the inflationary gap. Show your calculations. b. Using fiscal fixed tax policy, correct the inflationary gap. Show all calculations.

Explanation / Answer

PART-a) Multiplier = 1/rr = 1 / 0.05 = 20%

The money multiplier is 20, thus money supply must be reduced by 30 million (=600 million/ 20)

PART- b) Consumption = (15000 * 12) - 40,000 = 140,000

The MPC is 0.78 (=140,000 / (15,000*12)

Tax multiplier is 3.5 (=1 / (1-0.78) - 1)

Thus, taxes must be increased by $171.429 million (=600 million/ 3.5)

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