3. Suppose the economy is in a recession and policymakers estimate that AD is $1

Question

3. Suppose the economy is in a recession and policymakers estimate that AD is $10 million short of the amount necessary to achieve potential output i.e. if the AD curve would shift rightward by $10 million, the recessionary gap could be closed. If the marginal propensity to consume is 0.75, the economy does not trade and there is no crowding out, by how much should the government increase its spending to close the recessionary gap?

$_____ million Please enter 1 digit after the decimal point.

Please provide sample calculations with explination.

Explanation / Answer

Multiplier = 1 / (1 - 0.75) = 4

= $10 / 4

= $2.5 million.

Thus, when the marginal propensity to consume is 0.75, the economy does not trade and there is no crowding out, government shoulld increase its spending to close the recessionary gap by $2.5 million

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